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 Brief Contents
Preface xxiii

PA R T 1 Chapter 1 The Corporation 2

Introduction Chapter 2 Introduction to Financial Statement Analysis 22

PA R T 2 Chapter 3 Arbitrage and Financial Decision Making 56

Tools Chapter 4 The Time Value of Money 92
Chapter 5 Interest Rates 139

PA R T 3 Chapter 6 Valuing Bonds 168

Basic Valuation Chapter 7 Valuing Stocks 207
Chapter 8 Investment Decision Rules 247
Chapter 9 Fundamentals of Capital Budgeting 276

PA R T 4 Chapter 10 Capital Markets and the Pricing of Risk 319

Risk and Return Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 359
Chapter 12 Estimating the Cost of Capital 411
Chapter 13 Investor Behaviour and Capital Market Efficiency 447

PA R T 5 Chapter 14 Financial Options 485

Options Chapter 15 Option Valuation 519
Chapter 16 Real Options 554

PA R T 6 Chapter 17 Capital Structure in a Perfect Market 588

Capital Structure and Chapter 18 Debt and Taxes 617
Dividend Policy Chapter 19 Financial Distress, Managerial Incentives, and Information 648
Chapter 20 Payout Policy 693

PA R T 7 Chapter 21 Capital Budgeting and Valuation with Leverage 735

Valuation Chapter 22 Valuation and Financial Modelling: A Case Study 782

PA R T 8 Chapter 23 The Mechanics of Raising Equity Capital 816

Long-Term Financing Chapter 24 Debt Financing 846
Chapter 25 Leasing 868

PA R T 9 Chapter 26 Working Capital Management 896

Short-Term Financing Chapter 27 Short-Term Financial Planning 917

PA R T 1 0 Chapter 28 Mergers and Acquisitions 940

Special Topics Chapter 29 Corporate Governance 971
Chapter 30 Risk Management 996
Chapter 31 International Corporate Finance 1048

Glossary G-1

Index I-1
 Contents
ABOUT THE AUTHORS XXI 2.3 BALANCE SHEET ANALYSIS 28
PREFACE XXIII
2.4 THE INCOME STATEMENT 31
EARNINGS CALCULATIONS 31
PART 1 INTRODUCTION 1
2.5 INCOME STATEMENT ANALYSIS 33
Chapter 1 The Corporation 2 PROFITABILITY RATIOS 33
THE DUPONT IDENTITY 35
1.1 THE THREE TYPES OF FIRMS 3
■ COMMON MISTAKE: MISMATCHED RATIOS 36
SOLE PROPRIETORSHIPS 3
PARTNERSHIPS 3 2.6 THE STATEMENT OF CASH FLOWS 38
CORPORATIONS 4 OPERATING ACTIVITY 38
TAX IMPLICATIONS FOR CORPORATE ENTITIES 6 INVESTMENT ACTIVITY 39
FINANCING ACTIVITY 40
1.2 OWNERSHIP VERSUS
CONTROL OF CORPORATIONS 8 2.7 OTHER FINANCIAL STATEMENT
INFORMATION 41
THE CORPORATE MANAGEMENT TEAM 8
THE FINANCIAL MANAGER 8 MANAGEMENT DISCUSSION AND ANALYSIS 41
OWNERSHIP AND CONTROL OF CORPORATIONS 9 STATEMENT OF SHAREHOLDERS’ EQUITY 41
ETHICS AND INCENTIVES WITHIN STATEMENT OF COMPREHENSIVE INCOME 41
CORPORATIONS 10 NOTES TO THE FINANCIAL STATEMENTS 41
■ INTERVIEW WITH MICHAEL SCOTT 13 ■ INTERVIEW WITH SUE FRIEDEN 42
■ FINANCIAL CRISIS LEHMAN BROTHERS 2.8 ACCOUNTING MANIPULATION 44
BANKRUPTCY 14
ENRON 44
1.3 THE STOCK MARKET 15 WORLDCOM 44
PRIMARY AND SECONDARY STOCK MARKETS 15 ■ FINANCIAL CRISIS: BERNARD MADOFF’S
THE LARGEST STOCK MARKETS 15 PONZI SCHEME 45

TSX 18 SARBANES-OXLEY ACT 45

NYSE 18 SUMMARY 46 KEY TERMS 47 PROBLEMS 48
SUMMARY 18 KEY TERMS 19 PROBLEMS 20

Chapter 2 Introduction to Financial PART 2 TOOLS 55

Statement Analysis 22 Chapter 3 Arbitrage and Financial Decision
2.1 THE DISCLOSURE OF FINANCIAL Making 56
INFORMATION 23 3.1 VALUING DECISIONS 57
PREPARATION OF FINANCIAL STATEMENTS 23 ANALYZING COSTS AND BENEFITS 58
TYPES OF FINANCIAL STATEMENTS 23 USING MARKET PRICES TO DETERMINE
■ INTERNATIONAL FINANCIAL REPORTING CASH VALUES 58
STANDARDS 24 WHEN COMPETITIVE MARKET PRICES
2.2 THE BALANCE SHEET 24 ARE NOT AVAILABLE 60

ASSETS 25 3.2 INTEREST RATES AND THE TIME VALUE

LIABILITIES 26 OF MONEY 61
SHAREHOLDERS’ EQUITY 27 THE TIME VALUE OF MONEY 61
viii Contents
THE INTEREST RATE: AN EXCHANGE RATE
ACROSS TIME 61
3.3 PRESENT VALUE AND THE NPV
DECISION RULE 64
NET PRESENT VALUE 64
THE NPV DECISION RULE 65
NPV AND THE INDIVIDUAL’S CONSUMPTION
PREFERENCES 67
3.4 ARBITRAGE AND THE LAW OF ONE
PRICE 68
■ AN OLD JOKE 69
ARBITRAGE 69
LAW OF ONE PRICE 69
3.5 NO-ARBITRAGE AND SECURITY
PRICES 70
VALUING A SECURITY WITH THE
LAW OF ONE PRICE 70
DETERMINING THE NO-ARBITRAGE PRICE 71
■ NASDAQ SOES BANDITS 72
DETERMINING THE INTEREST RATE FROM
BOND PRICES 73
THE NPV OF TRADING SECURITIES AND THE
OPTIMAL INVESTMENT DECISION 73
VALUING A PORTFOLIO 75
■ NO-ARBITRAGE PRICES OF
EXCHANGE-TRADED FUNDS 76
3.6 THE PRICE OF RISK 77
RISKY VERSUS RISK-FREE CASH FLOWS 77
RISK AVERSION AND THE RISK PREMIUM 77
THE NO-ARBITRAGE PRICE OF A RISKY
SECURITY 78
RISK PREMIUMS DEPEND ON RISK 79
RISK IS RELATIVE TO THE OVERALL
MARKET 79
RISK, RETURN, AND MARKET PRICES 81
3.7 ARBITRAGE WITH TRANSACTIONS
COSTS 82
■ FINANCIAL CRISIS: LIQUIDITY AND THE
INFORMATIONAL ROLE OF PRICES 83
WHERE DO WE GO FROM HERE? 85
SUMMARY 85 KEY TERMS 86 PROBLEMS 87
Chapter 4 The Time Value of Money 92
4.1 THE TIMELINE 93
4.2 THE THREE RULES OF TIME TRAVEL 94
RULE 1: ONLY CASH FLOW VALUES AT THE SAME
POINT IN TIME CAN BE COMPARED
OR COMBINED 94
RULE 2: TO MOVE A CASH FLOW FORWARD IN
TIME, YOU MUST COMPOUND IT 95
■ RULE OF 72 97
RULE 3: TO MOVE A CASH FLOW BACKWARD IN
TIME, YOU MUST DISCOUNT IT 97
APPLYING THE RULES OF TIME TRAVEL 98
4.3 VALUING A STREAM OF CASH
FLOWS 100
4.4 CALCULATING THE NET PRESENT
VALUE 103
■ CALCULATING PRESENT VALUES IN EXCEL 104
4.5 PERPETUITIES AND ANNUITIES 105
REGULAR PERPETUITIES 105
■ HISTORICAL EXAMPLES OF PERPETUITIES 106
ANNUITIES 107
■ COMMON MISTAKE DISCOUNTING ONE TOO
MANY TIMES 108
GROWING CASH FLOWS 111
4.6 SOLVING PROBLEMS WITH A
SPREADSHEET 117
4.7 NON-ANNUAL TIME INTERVALS 119
4.8 SOLVING FOR THE CASH FLOWS 120
4.9 THE INTERNAL RATE OF RETURN 122
■ EXCEL’S IRR FUNCTION 126
4.10 SOLVING FOR THE NUMBER OF
PERIODS 126
SUMMARY 128 KEY TERMS 129 PROBLEMS 130
CHAPTER 4 APPENDIX:
USING A FINANCIAL CALCULATOR 136
Chapter 5 Interest Rates 139
5.1 INTEREST RATE QUOTES AND
ADJUSTMENTS 140
THE EFFECTIVE ANNUAL RATE 140
ADJUSTING THE EFFECTIVE ANNUAL RATE TO AN
EFFECTIVE RATE OVER DIFFERENT TIME
PERIODS 140
ANNUAL PERCENTAGE RATES 141
5.2 APPLICATION: DISCOUNT RATES
AND LOANS 146
 Contents ix

5.3 THE DETERMINANTS OF INTEREST BOND RATINGS 187

RATES 148 CORPORATE YIELD CURVES 189

INFLATION AND REAL VERSUS NOMINAL RATES 148 ■ FINANCIAL CRISIS THE CREDIT CRISIS AND BOND
YIELDS 190
INVESTMENT AND INTEREST RATE POLICY 150
THE YIELD CURVE AND DISCOUNT RATES 150 6.5 SOVEREIGN BONDS 191
THE YIELD CURVE AND THE ECONOMY 152 ■ GLOBAL FINANCIAL CRISIS EUROPEAN SOVEREIGN
■ COMMON MISTAKE USING THE ANNUITY FORMULA DEBT YIELDS: A PUZZLE 192
WHEN DISCOUNT RATES VARY 152 ■ INTERVIEW WITH CARMEN M. REINHART 193
■ INTERVIEW WITH KEVIN M. WARSH 153
SUMMARY 194 KEY TERMS 195
5.4 RISK AND TAXES 155 PROBLEMS 196
RISK AND INTEREST RATES 155 CHAPTER 6 APPENDIX:
AFTER-TAX INTEREST RATES 156 FORWARD INTEREST RATES AND THEORIES
OF THE TERM STRUCTURE OF INTEREST
5.5 THE OPPORTUNITY COST OF RATES 202
CAPITAL 158
Chapter 7 Valuing Stocks 207
SUMMARY 159 KEY TERMS 160
PROBLEMS 160 7.1 THE DIVIDEND-DISCOUNT MODEL 208
CHAPTER 5 APPENDIX: A ONE-YEAR INVESTOR 208
CONTINUOUS RATES AND CASH FLOWS 165 DIVIDEND YIELDS, CAPITAL GAINS, AND TOTAL
RETURNS 209
A MULTIYEAR INVESTOR 210
PART 3 BASIC VALUATION 167 THE DIVIDEND-DISCOUNT MODEL EQUATION 210
Chapter 6 Valuing Bonds 168 7.2 APPLYING THE DIVIDEND-DISCOUNT
6.1 BOND CASH FLOWS, PRICES, AND MODEL 211
YIELDS 169 CONSTANT DIVIDEND GROWTH 211
DIVIDENDS VERSUS INVESTMENT AND
BOND TERMINOLOGY 169
GROWTH 212
ZERO-COUPON BONDS 170
CHANGING GROWTH RATES 215
■ FINANCIAL CRISIS PURE DISCOUNT BONDS TRADING
LIMITATIONS OF THE DIVIDEND-DISCOUNT
AT A PREMIUM 172
MODEL 216
COUPON BONDS 172
■ JOHN BURR WILLIAMS’ THEORY OF INVESTMENT
6.2 DYNAMIC BEHAVIOUR OF BOND VALUE 217
PRICES 175
7.3 TOTAL PAYOUT AND FREE CASH FLOW
DISCOUNTS AND PREMIUMS 175 VALUATION MODELS 217
TIME AND BOND PRICES 176
SHARE REPURCHASES AND THE TOTAL PAYOUT
■ CLEAN AND DIRTY PRICES FOR COUPON BONDS 178 MODEL 217
INTEREST RATE CHANGES AND BOND PRICES 179 THE DISCOUNTED FREE CASH FLOW MODEL 219
6.3 THE YIELD CURVE AND BOND ■ INTERVIEW WITH DOUGLAS KEHRING 224
ARBITRAGE 181 7.4 VALUATION BASED ON COMPARABLE
REPLICATING A COUPON BOND 181 FIRMS 225
VALUING A COUPON BOND USING ZERO-COUPON VALUATION MULTIPLES 225
YIELDS OR SPOT RATES OF INTEREST 182
LIMITATIONS OF MULTIPLES 227
COUPON BOND YIELDS 183
COMPARISON WITH DISCOUNTED CASH FLOW
COUPON-PAYING YIELD CURVE 184 METHODS 229
6.4 CORPORATE BONDS 185 STOCK VALUATION TECHNIQUES:
THE FINAL WORD 229
CORPORATE BOND YIELDS 185
x Contents
7.5 INFORMATION, COMPETITION,
AND STOCK PRICES 230
INFORMATION IN STOCK PRICES 231
COMPETITION AND EFFICIENT MARKETS 232
LESSONS FOR INVESTORS AND
Chapter 9 Fundamentals of Capital
CORPORATE MANAGERS 234
■ INTERVIEW WITH RANDY COUSINS 236
THE EFFICIENT MARKETS HYPOTHESIS
VERSUS NO ARBITRAGE 237
SUMMARY 238 KEY TERMS 240
PROBLEMS 241
Chapter 8 Investment Decision Rules 247
8.1 NPV AND STAND-ALONE PROJECTS 248
APPLYING THE NPV RULE 248
MEASURING SENSITIVITY WITH IRR 249
ALTERNATIVE RULES VERSUS THE NPV RULE 249
■ INTERVIEW WITH DICK GRANNIS 250
8.2 THE INTERNAL RATE OF RETURN
RULE 251
IRR RULE EXAMPLE 251
UNCONVENTIONAL CASH FLOWS 251
MULTIPLE IRRs 252
NONEXISTENT IRR 254
■ COMPUTING THE NPV PROFILE OF
AN INVESTMENT 256
■ THE IRR VERSUS THE IRR RULE 257
8.3 THE PAYBACK RULE 258
APPLYING THE PAYBACK RULE 258
PAYBACK RULE PITFALLS IN PRACTICE 258
8.4 CHOOSING BETWEEN PROJECTS 259
THE NPV RULE AND MUTUALLY EXCLUSIVE
PROJECTS 259
IRR RULE AND MUTUALLY EXCLUSIVE
PROJECTS 260
DIFFERENCES IN SCALE 260
DIFFERENCES IN TIMING 261
DIFFERENCES IN RISK 261
THE INCREMENTAL IRR RULE 262
■ COMMON MISTAKE IRR AND PROJECT FINANCING 264
■ WHEN CAN RETURNS BE COMPARED? 264
8.5 PROJECT SELECTION WITH RESOURCE
CONSTRAINTS 265
Chapter 10 Capital Markets and the Pricing
EVALUATION OF PROJECTS WITH DIFFERENT
RESOURCE REQUIREMENTS 265
PROFITABILITY INDEX 267
CAPITAL RATIONING CONSTRAINTS 267
SHORTCOMINGS OF THE PROFITABILITY INDEX 267
SUMMARY 268 KEY TERMS 268
PROBLEMS 269
Budgeting 276
9.1 FORECASTING EARNINGS 277
REVENUE AND COST ESTIMATES 277
INCREMENTAL EARNINGS FORECAST 278
■ CANADA REVENUE AGENCY’S CAPITAL COST ALLOW-
ANCE ASSET CLASSES AND CCA RATES 279
INDIRECT EFFECTS ON INCREMENTAL
EARNINGS 282
■ COMMON MISTAKE THE OPPORTUNITY COST OF AN
IDLE ASSET 284
SUNK COSTS AND INCREMENTAL
EARNINGS 284
■ THE SUNK COST FALLACY 285
REAL-WORLD COMPLEXITIES 285
9.2 DETERMINING FREE CASH FLOW
AND NPV 286
CALCULATING THE FREE CASH FLOW FROM
EARNINGS 286
CALCULATING FREE CASH FLOW DIRECTLY 289
CALCULATING THE NPV 290
9.3 CHOOSING AMONG ALTERNATIVES 291
9.4 FURTHER ADJUSTMENTS TO FREE
CASH FLOW 293
9.5 ANALYZING THE PROJECT 301
BREAK-EVEN ANALYSIS 302
SENSITIVITY ANALYSIS 303
SCENARIO ANALYSIS 304
■ INTERVIEW WITH DAVID HOLLAND 306
SUMMARY 307 KEY TERMS 308
PROBLEMS 308
CHAPTER 9 APPENDIX:
THE EFFECTS OF ASSET SALES ON
CCA CALCULATIONS 314
PART 4 RISK AND RETURN 319
of Risk 320
10.1 A FIRST LOOK AT RISK AND RETURN 321

10.2 COMMON MEASURES OF RISK
AND RETURN 323
PROBABILITY DISTRIBUTIONS 323
EXPECTED RETURN 324
VARIANCE AND STANDARD DEVIATION 325
10.3 HISTORICAL RETURNS OF STOCKS AND
BONDS 327
COMPUTING HISTORICAL RETURNS 327
AVERAGE ANNUAL RETURNS 330
THE VARIANCE AND VOLATILITY OF RETURNS 331
USING PAST RETURNS TO PREDICT THE FUTURE:
ESTIMATION ERROR 333
■ ARITHMETIC AVERAGE RETURNS VERSUS
COMPOUND ANNUAL RETURNS 334
10.4 THE HISTORICAL TRADEOFF BETWEEN
RISK AND RETURN 335
THE RETURNS OF LARGE PORTFOLIOS 335
THE RETURNS OF INDIVIDUAL STOCKS 337
10.5 COMMON VERSUS INDEPENDENT
RISK 338
THEFT VERSUS EARTHQUAKE INSURANCE:
AN EXAMPLE 338
THE ROLE OF DIVERSIFICATION 339
10.6 DIVERSIFICATION IN STOCK
PORTFOLIOS 341
FIRM-SPECIFIC VERSUS SYSTEMATIC RISK 341
NO ARBITRAGE AND THE RISK PREMIUM 343
■ FINANCIAL CRISIS DIVERSIFICATION BENEFITS
DURING MARKET CRASHES 344
■ COMMON MISTAKE A FALLACY OF LONG-RUN
DIVERSIFICATION 345
10.7 MEASURING SYSTEMATIC RISK 346
AN INVESTMENT’S SENSITIVITY TO
SYSTEMATIC RISK 346
BETA AND SYSTEMATIC RISK 347
10.8 BETA AND THE COST OF CAPITAL 350
ESTIMATING THE RISK PREMIUM 350
■ COMMON MISTAKE BETA VERSUS VOLATILITY 351
THE CAPITAL ASSET PRICING MODEL 352
■ INTERVIEW WITH RANDALL LERT 352
SUMMARY 353 KEY TERMS 354
PROBLEMS 355
Chapter 11 Optimal Portfolio Choice and the
Capital Asset Pricing Model 359
Contents xi
11.1 THE EXPECTED RETURN OF A
PORTFOLIO 360
11.2 THE VOLATILITY OF A TWO-STOCK
PORTFOLIO 362
COMBINING RISKS 362
DETERMINING COVARIANCE AND CORRELATION 363
■ COMPUTING THE VARIANCE, COVARIANCE,
AND CORRELATION IN MICROSOFT EXCEL 367
COMPUTING A PORTFOLIO’S VARIANCE
AND VOLATILITY 368
11.3 THE VOLATILITY OF A LARGE
PORTFOLIO 369
LARGE PORTFOLIO VARIANCE 369
DIVERSIFICATION WITH AN EQUALLY WEIGHTED
PORTFOLIO 370
DIVERSIFICATION WITH GENERAL PORTFOLIOS 372
11.4 RISK VERSUS RETURN: CHOOSING AN
EFFICIENT PORTFOLIO 373
EFFICIENT PORTFOLIOS WITH TWO STOCKS 373
THE EFFECT OF CORRELATION 375
SHORT SALES 376
■ THE MECHANICS OF A SHORT SALE 378
EFFICIENT PORTFOLIOS WITH MANY STOCKS 379
11.5 RISK-FREE SAVING AND
BORROWING 381
INVESTING IN RISK-FREE SECURITIES 381
BORROWING AND BUYING STOCKS ON
MARGIN 382
IDENTIFYING THE TANGENT PORTFOLIO 383
11.6 THE EFFICIENT PORTFOLIO AND
REQUIRED RETURNS 385
PORTFOLIO IMPROVEMENT: BETA AND THE
REQUIRED RETURN 386
EXPECTED RETURNS AND THE EFFICIENT
PORTFOLIO 387
■ INTERVIEW WITH MANMEET BHATIA 388
■ NOBEL PRIZE HARRY MARKOWITZ
AND JAMES TOBIN 390
11.7 THE CAPITAL ASSET PRICING MODEL 391
THE CAPM ASSUMPTIONS 391
SUPPLY, DEMAND, AND THE EFFICIENCY OF THE
MARKET PORTFOLIO 391
OPTIMAL INVESTING: THE CAPITAL
MARKET LINE 392
11.8 DETERMINING THE RISK PREMIUM 393
xii Contents
MARKET RISK AND BETA 393
THE SECURITY MARKET LINE 394
BETA OF A PORTFOLIO 396
SUMMARY OF THE CAPITAL ASSET PRICING
MODEL 397
■ NOBEL PRIZE WILLIAM SHARPE ON THE CAPM 398
SUMMARY 398 KEY TERMS 401
PROBLEMS 401
CHAPTER 11 APPENDIX:
THE CAPM WITH DIFFERING
INTEREST RATES 408
Chapter 12 Estimating the Cost of
Capital 411
12.1 THE EQUITY COST OF CAPITAL 412
12.2 THE MARKET PORTFOLIO 413
CONSTRUCTING THE MARKET PORTFOLIO 413
MARKET INDEXES 413
■ VALUE-WEIGHTED PORTFOLIOS AND
REBALANCING 414
■ INTERVIEW WITH MICHAEL A. LATHAM 417
12.3 THE MARKET RISK PREMIUM 418
12.4 BETA ESTIMATION 420
USING HISTORICAL RETURNS 421
IDENTIFYING THE CHARACTERISTIC LINE 422
USING LINEAR REGRESSION 423
■ WHY NOT ESTIMATE EXPECTED RETURNS
DIRECTLY? 424
12.5 THE DEBT COST OF CAPITAL 425
DEBT YIELDS 425
DEBT BETAS 426
■ COMMON MISTAKE USING THE DEBT YIELD AS ITS
COST OF CAPITAL 427
12.6 A PROJECT’S COST OF CAPITAL 427
ALL-EQUITY COMPARABLES 427
LEVERED FIRMS AS COMPARABLES 428
THE UNLEVERED COST OF CAPITAL 429
INDUSTRY ASSET BETAS 431
12.7 PROJECT COST OF CAPITAL:
RISK CHARACTERISTICS AND
FINANCING 433
PROJECT RISK CHARACTERISTICS 433
PROJECT FINANCING AND THE WEIGHTED
AVERAGE COST OF CAPITAL 434
■ COMMON MISTAKE ADJUSTING FOR
EXECUTION RISK 434
FINAL THOUGHTS ON USING THE CAPM 436
SUMMARY 437 KEY TERMS 438
PROBLEMS 439
CHAPTER 12 APPENDIX:
PRACTICAL CONSIDERATIONS WHEN
FORECASTING BETA 444
Chapter 13 Investor Behaviour and Capital
Market Efficiency 447
13.1 COMPETITION AND CAPITAL
MARKETS 448
IDENTIFYING A STOCK’S ALPHA 448
PROFITING FROM NON-ZERO ALPHA STOCKS 450
13.2 INFORMATION AND RATIONAL
EXPECTATIONS 450
INFORMED VERSUS UNINFORMED INVESTORS 451
RATIONAL EXPECTATIONS 452
13.3 THE BEHAVIOUR OF INDIVIDUAL
INVESTORS 452
UNDERDIVERSIFICATION AND PORTFOLIO
BIASES 453
EXCESSIVE TRADING AND OVERCONFIDENCE 453
INDIVIDUAL BEHAVIOUR AND MARKET PRICES 455
■ INTERVIEW WITH JONATHAN CLEMENTS 456
13.4 SYSTEMATIC TRADING BIASES 457
HANGING ON TO LOSERS AND THE DISPOSITION
EFFECT 457
■ NOBEL PRIZE KAHNEMAN AND TVERSKY’S
PROSPECT THEORY 458
INVESTOR ATTENTION, MOOD, AND
EXPERIENCE 458
HERD BEHAVIOUR 459
IMPLICATIONS OF BEHAVIOURAL BIASES 459
13.5 THE EFFICIENCY OF THE MARKET
PORTFOLIO 460
TRADING ON NEWS OR RECOMMENDATIONS 460
THE PERFORMANCE OF FUND MANAGERS 461
THE WINNERS AND LOSERS 463
■ INTERVIEW WITH JOHN BOGLE 465
13.6 STYLE-BASED TECHNIQUES AND THE
MARKET EFFICIENCY DEBATE 466
SIZE EFFECTS 466
MOMENTUM 469

IMPLICATIONS OF POSITIVE-ALPHA TRADING
STRATEGIES 469
13.7 MULTIFACTOR MODELS OF RISK 471
USING FACTOR PORTFOLIOS 472
SELECTING THE PORTFOLIOS 473
THE COST OF CAPITAL WITH FAMA-FRENCH-
CARHART FACTOR SPECIFICATION 474
13.8 METHODS USED IN PRACTICE 476
SUMMARY 477 KEY TERMS 479
PROBLEMS 479
CHAPTER 13 APPENDIX:
BUILDING A MULTIFACTOR MODEL 484
PART 5 OPTIONS 485
Chapter 14 Financial Options 486
14.1 OPTION BASICS 487
UNDERSTANDING OPTION CONTRACTS 487
INTERPRETING STOCK OPTION QUOTATIONS 487
OPTIONS ON OTHER FINANCIAL SECURITIES 489
14.2 OPTION PAYOFFS AT EXPIRATION 490
LONG POSITION IN AN OPTION CONTRACT 490
SHORT POSITION IN AN OPTION CONTRACT 492
PROFITS FOR HOLDING AN OPTION TO
EXPIRATION 493
RETURNS FOR HOLDING AN OPTION TO
EXPIRATION 494
COMBINATIONS OF OPTIONS 496
14.3 PUT–CALL PARITY 499
14.4 FACTORS AFFECTING OPTION
PRICES 501
STRIKE PRICE AND STOCK PRICE 501
ARBITRAGE BOUNDS ON OPTION PRICES 501
OPTION PRICES AND THE EXPIRATION DATE 502
OPTION PRICES AND VOLATILITY 502
14.5 EXERCISING OPTIONS EARLY 503
NON-DIVIDEND-PAYING STOCKS 503
DIVIDEND-PAYING STOCKS 506
14.6 OPTIONS AND CORPORATE
FINANCE 508
EQUITY AS A CALL OPTION 509
DEBT AS AN OPTION PORTFOLIO 509
■ FINANCIAL CRISIS CREDIT DEFAULT SWAPS 511
Contents xiii
PRICING RISKY DEBT 511
SUMMARY 513 KEY TERMS 514
PROBLEMS 514
Chapter 15 Option Valuation 519
15.1 THE BINOMIAL OPTION PRICING
MODEL 520
A TWO-STATE SINGLE-PERIOD MODEL 520
THE BINOMIAL PRICING FORMULA 522
A MULTIPERIOD MODEL 524
15.2 THE BLACK-SCHOLES OPTION PRICING
MODEL 528
THE BLACK-SCHOLES FORMULA 528
■ COMMON MISTAKE VALUING EMPLOYEE
STOCK OPTIONS 533
IMPLIED VOLATILITY 534
THE REPLICATING PORTFOLIO 536
■ FINANCIAL CRISIS THE VIX INDEX 536
■ INTERVIEW WITH MYRON S. SCHOLES 539
■ NOBEL PRIZE THE 1997 NOBEL PRIZE IN
ECONOMICS 540
15.3 RISK-NEUTRAL PROBABILITIES 540
A RISK-NEUTRAL TWO-STATE MODEL 540
IMPLICATIONS OF THE RISK-NEUTRAL WORLD 541
RISK-NEUTRAL PROBABILITIES AND OPTION
PRICING 542
15.4 RISK AND RETURN OF AN OPTION 543
15.5 CORPORATE APPLICATIONS 545
BETA OF RISKY DEBT 546
DEBT OVERHANG 548
SUMMARY 548 KEY TERMS 550
PROBLEMS 550
Chapter 16 Real Options 554
16.1 REAL VERSUS FINANCIAL OPTIONS 555
16.2 DECISION TREE ANALYSIS 555
MAPPING UNCERTAINTIES ON A
DECISION TREE 556
REAL OPTIONS 557
16.3 THE OPTION TO DELAY AN INVESTMENT
OPPORTUNITY 558
INVESTMENT AS A CALL OPTION 558
FACTORS AFFECTING THE TIMING OF
INVESTMENT 560
xiv Contents

■ WHY ARE THERE EMPTY LOTS IN BUILT-UP AREAS OF THE MARKET VALUE BALANCE SHEET 596
BIG CITIES? 562 APPLICATION: A LEVERAGED
INVESTMENT OPTIONS AND FIRM RISK 563 RECAPITALIZATION 597
■ FINANCIAL CRISIS UNCERTAINTY, INVESTMENT,
17.3 MODIGLIANI-MILLER II: LEVERAGE,
AND THE OPTION TO DELAY 564
RISK, AND THE COST OF CAPITAL 598
16.4 GROWTH AND ABANDONMENT LEVERAGE AND THE EQUITY COST OF CAPITAL 599
OPTIONS 564
CAPITAL BUDGETING AND THE WEIGHTED
VALUING GROWTH POTENTIAL 565 AVERAGE COST OF CAPITAL 600
STAGED INVESTMENT: THE OPTION TO ■ COMMON MISTAKE IS DEBT BETTER THAN
EXPAND 567 EQUITY? 602
■ INTERVIEW WITH SCOTT MATHEWS 568 COMPUTING THE WACC WITH MULTIPLE
THE OPTION TO ABANDON 569 SECURITIES 602
THE OPTION TO SHUT DOWN 569 LEVERED AND UNLEVERED BETAS 603
CASH AND THE WACC 604
16.5 APPLICATIONS TO MULTIPLE
PROJECTS 571 17.4 CAPITAL STRUCTURE FALLACIES 605
COMPARING MUTUALLY EXCLUSIVE INVESTMENTS LEVERAGE AND EARNINGS PER SHARE 605
WITH DIFFERENT LIVES 571 EQUITY ISSUANCES AND DILUTION 607
STAGING MUTUALLY DEPENDENT ■ FINANCIAL CRISIS BANK CAPITAL REGULATION
INVESTMENTS 573 AND THE ROE FALLACY 608
■ EQUIVALENT ANNUAL BENEFIT METHOD 574
17.5 MM: BEYOND THE PROPOSITIONS 609
16.6 RULES OF THUMB 577 ■ NOBEL PRIZE FRANCO MODIGLIANI AND
THE PROFITABILITY INDEX RULE 577 MERTON MILLER 610

THE HURDLE RATE RULE 578 SUMMARY 611 KEY TERMS 612
APPLYING HURDLE RATES AND THE PROFITABILITY PROBLEMS 612
INDEX SIMULTANEOUSLY 580
Chapter 18 Debt and Taxes 617
16.7 KEY INSIGHTS FROM REAL
OPTIONS 580 18.1 THE INTEREST TAX DEDUCTION 618

SUMMARY 581 KEY TERMS 582 18.2 VALUING THE INTEREST TAX SHIELD 620
PROBLEMS 582 THE INTEREST TAX SHIELD AND FIRM VALUE 620
THE INTEREST TAX SHIELD WITH
PERMANENT DEBT 622
PART 6 CAPITAL STRUCTURE AND ■ PIZZA AND TAXES 622
DIVIDEND POLICY 587
THE WEIGHTED AVERAGE COST OF CAPITAL
Chapter 17 Capital Structure in a Perfect WITH TAXES 623
THE INTEREST TAX SHIELD WITH A TARGET
Market 588
DEBT–EQUITY RATIO 625
17.1 EQUITY VERSUS DEBT FINANCING 589
18.3 RECAPITALIZING TO CAPTURE THE
FINANCING A FIRM WITH EQUITY 589 TAX SHIELD 626
FINANCING A FIRM WITH DEBT AND EQUITY 590
THE TAX BENEFIT 626
THE EFFECT OF LEVERAGE ON RISK
THE SHARE REPURCHASE 626
AND RETURN 591
NO ARBITRAGE PRICING 627
17.2 MODIGLIANI-MILLER I: LEVERAGE, ANALYZING THE RECAP: THE MARKET VALUE
ARBITRAGE, AND FIRM VALUE 593 BALANCE SHEET 627
MM AND THE LAW OF ONE PRICE 593 18.4 PERSONAL TAXES 629
HOMEMADE LEVERAGE 593
INCLUDING PERSONAL TAXES IN THE INTEREST
■ MM AND THE REAL WORLD 594 TAX SHIELD 629

VALUING THE INTEREST TAX SHIELD WITH
PERSONAL TAXES 633
DETERMINING THE ACTUAL TAX ADVANTAGE
OF DEBT 633
■ CUTTING PERSONAL TAXES ON INVESTMENT
INCOME 634
18.5 OPTIMAL CAPITAL STRUCTURE WITH
TAXES 634
DO FIRMS PREFER DEBT? 635
LIMITS TO THE TAX BENEFIT OF DEBT 638
GROWTH AND DEBT 639
OTHER TAX SHIELDS 640
THE LOW LEVERAGE PUZZLE 640
SUMMARY 643 KEY TERM 644
PROBLEMS 644
Chapter 19 Financial Distress, Managerial
Incentives, and Information 648
19.1 DEFAULT AND BANKRUPTCY IN A
PERFECT MARKET 649
ARMIN INDUSTRIES: LEVERAGE AND THE
RISK OF DEFAULT 649
BANKRUPTCY AND CAPITAL STRUCTURE 651
19.2 THE COSTS OF BANKRUPTCY AND
FINANCIAL DISTRESS 652
BANKRUPTCY LAW 652
DIRECT COSTS OF BANKRUPTCY 653
INDIRECT COSTS OF FINANCIAL DISTRESS 654
19.3 FINANCIAL DISTRESS COSTS AND FIRM
VALUE 657
ARMIN INDUSTRIES: THE IMPACT OF FINANCIAL
DISTRESS COSTS 657
WHO PAYS FOR FINANCIAL DISTRESS
COSTS? 657
19.4 OPTIMAL CAPITAL STRUCTURE: THE
TRADEOFF THEORY 659
THE PRESENT VALUE OF FINANCIAL
DISTRESS COSTS 659
OPTIMAL LEVERAGE 660
19.5 EXPLOITING DEBT HOLDERS: THE
AGENCY COSTS OF DEBT 662
EXCESSIVE RISK-TAKING AND ASSET
SUBSTITUTION 662
DEBT OVERHANG AND UNDER-INVESTMENT 663
CASHING OUT 664
Contents xv
■ FINANCIAL CRISIS BAILOUTS, DISTRESS COSTS,
AND DEBT OVERHANG 665
AGENCY COSTS OF DEBT AND THE VALUE
OF LEVERAGE 666
DEBT MATURITY AND COVENANTS 667
19.6 MOTIVATING MANAGERS: THE
AGENCY BENEFITS OF DEBT 667
CONCENTRATION OF OWNERSHIP 668
REDUCTION OF WASTEFUL INVESTMENT 668
■ EXCESSIVE PERKS AND CORPORATE
SCANDALS 669
■ FINANCIAL CRISIS MORAL HAZARD,
GOVERNMENT BAILOUTS, AND THE APPEAL
OF LEVERAGE 670
LEVERAGE AND COMMITMENT 671
19.7 AGENCY COSTS AND THE TRADEOFF
THEORY 672
THE OPTIMAL DEBT LEVEL 673
DEBT LEVELS IN PRACTICE 673
19.8 ASYMMETRIC INFORMATION AND
CAPITAL STRUCTURE 674
LEVERAGE AS A CREDIBLE SIGNAL 674
ISSUING EQUITY AND ADVERSE SELECTION 676
■ NOBEL PRIZE THE 2001 NOBEL PRIZE IN
ECONOMICS 676
IMPLICATIONS FOR EQUITY ISSUANCE 678
IMPLICATIONS FOR CAPITAL STRUCTURE 679
■ INTERVIEW WITH PAUL JEWER 682
19.9 CAPITAL STRUCTURE: THE
BOTTOM LINE 683
SUMMARY 684 KEY TERMS 685
PROBLEMS 686
Chapter 20 Payout Policy 693
20.1 DISTRIBUTIONS TO
SHAREHOLDERS 694
DIVIDENDS 694
SHARE REPURCHASES 696
20.2 COMPARISON OF DIVIDENDS AND
SHARE REPURCHASES 697
ALTERNATIVE POLICY 1: PAY DIVIDEND WITH
EXCESS CASH 698
ALTERNATIVE POLICY 2: SHARE REPURCHASE
(NO DIVIDEND) 699
■ COMMON MISTAKE REPURCHASES
AND THE SUPPLY OF SHARES 700
xvi Contents
ALTERNATIVE POLICY 3: HIGH DIVIDEND
(EQUITY ISSUE) 700
MODIGLIANI-MILLER AND DIVIDEND POLICY
IRRELEVANCE 701
■ COMMON MISTAKE THE BIRD IN THE
HAND FALLACY 702
DIVIDEND POLICY WITH PERFECT CAPITAL
MARKETS 702
20.3 THE TAX DISADVANTAGE OF
DIVIDENDS 703
TAXES ON DIVIDENDS AND CAPITAL
GAINS 703
OPTIMAL DIVIDEND POLICY WITH TAXES 704
20.4 DIVIDEND CAPTURE AND TAX
CLIENTELES 706
THE EFFECTIVE DIVIDEND TAX RATE 706
TAX DIFFERENCES ACROSS INVESTORS 707
CLIENTELE EFFECTS 708
20.5 PAYOUT VERSUS RETENTION
OF CASH 711
RETAINING CASH WITH PERFECT CAPITAL
MARKETS 711
TAXES AND CASH RETENTION 712
ADJUSTING FOR INVESTOR TAXES 713
ISSUANCE AND DISTRESS COSTS 715
AGENCY COSTS OF RETAINING CASH 715
20.6 SIGNALLING WITH PAYOUT POLICY 717
DIVIDEND SMOOTHING 717
DIVIDEND SIGNALLING 718
■ ROYAL & SUNALLIANCE’S DIVIDEND CUT 719
SIGNALLING AND SHARE REPURCHASES 719
20.7 STOCK DIVIDENDS, SPLITS,
AND SPIN-OFFS 721
STOCK DIVIDENDS AND SPLITS 721
■ INTERVIEW WITH JOHN CONNORS 722
■ BERKSHIRE HATHAWAY’S A & B SHARES 724
SPIN-OFFS 725
SUMMARY 726 KEY TERMS 727
PROBLEMS 728
PART 7 VALUATION 733
Chapter 21 Capital Budgeting and Valuation
with Leverage 734
21.1 OVERVIEW 735
ASSUMPTIONS IN VALUATION EXAMPLE 735
RECAP: KEY VALUATION CONCEPTS 736
21.2 THE WEIGHTED AVERAGE COST OF
CAPITAL METHOD 736
USING THE WACC TO VALUE A PROJECT 737
SUMMARY OF THE WACC METHOD 738
IMPLEMENTING A CONSTANT
DEBT–EQUITY RATIO 739
21.3 THE ADJUSTED PRESENT VALUE
METHOD 741
THE UNLEVERED VALUE OF THE PROJECT 741
VALUING THE INTEREST TAX SHIELD 742
SUMMARY OF THE APV METHOD 743
21.4 THE FLOW-TO-EQUITY METHOD 745
CALCULATING THE FREE CASH FLOW TO
EQUITY 745
VALUING EQUITY CASH FLOWS 746
SUMMARY OF THE FLOW-TO-EQUITY METHOD 747
■ WHAT COUNTS AS “DEBT”? 749
21.5 PROJECT-BASED COSTS OF CAPITAL 749
ESTIMATING THE UNLEVERED COST OF
CAPITAL 749
PROJECT LEVERAGE AND THE EQUITY COST OF
CAPITAL 750
DETERMINING THE INCREMENTAL LEVERAGE OF A
PROJECT 751
■ COMMON MISTAKE RELEVERING THE WACC 752
21.6 APV WITH OTHER LEVERAGE
POLICIES 753
CONSTANT INTEREST COVERAGE RATIO 754
PREDETERMINED DEBT LEVELS 755
A COMPARISON OF METHODS 757
21.7 OTHER EFFECTS OF FINANCING 757
ISSUANCE AND OTHER FINANCING COSTS 757
SECURITY MISPRICING 758
■ FINANCIAL CRISIS GOVERNMENT LOAN
GUARANTEES 758
FINANCIAL DISTRESS AND AGENCY COSTS 759
21.8 ADVANCED TOPICS IN CAPITAL
BUDGETING 761
PERIODICALLY ADJUSTED DEBT 761
LEVERAGE AND THE COST OF CAPITAL 763
THE WACC OR FTE METHOD WITH CHANGING
LEVERAGE 765
PERSONAL TAXES 766
 Contents xvii

SUMMARY 769 KEY TERMS 770 PART 8 LONG-TERM FINANCING 815

PROBLEMS 771
CHAPTER 21 APPENDIX:
FOUNDATIONS AND FURTHER DETAILS 778
Chapter 22 Valuation and Financial
Modelling: A Case Study 782
22.1 VALUATION USING COMPARABLES 783
22.2 THE BUSINESS PLAN 785
OPERATIONAL IMPROVEMENTS 785
CAPITAL EXPENDITURES: A NEEDED
EXPANSION 787
WORKING CAPITAL MANAGEMENT 787
CAPITAL STRUCTURE CHANGES:
LEVERING UP 788
22.3 BUILDING THE FINANCIAL
MODEL 789
FORECASTING EARNINGS 789
WORKING CAPITAL REQUIREMENTS 791
FORECASTING FREE CASH FLOW 792
THE BALANCE SHEET AND STATEMENT OF
CASH FLOWS (OPTIONAL) 794
22.4 ESTIMATING THE COST OF
CAPITAL 797
CAPM-BASED ESTIMATION 797
UNLEVERING BETA 798
IDEKO’S UNLEVERED COST OF CAPITAL 798
22.5 VALUING THE INVESTMENT 800
THE MULTIPLES APPROACH TO CONTINUATION
VALUE 800
THE DISCOUNTED CASH FLOW APPROACH TO
CONTINUATION VALUE 801
APV VALUATION OF IDEKO EQUITY 802
■ COMMON MISTAKE CONTINUATION VALUES AND
LONG-RUN GROWTH 804
A REALITY CHECK 804
IRR AND CASH MULTIPLES 805
■ COMMON MISTAKE MISSING ASSETS OR
LIABILITIES 805
■ INTERVIEW WITH JOSEPH L. RICE, III 807
22.6 SENSITIVITY ANALYSIS 808
SUMMARY 809 KEY TERMS 810
PROBLEMS 810
CHAPTER 22 APPENDIX:
COMPENSATING MANAGEMENT 813
Chapter 23 The Mechanics of Raising
Equity Capital 816
23.1 EQUITY FINANCING FOR PRIVATE
COMPANIES 817
SOURCES OF FUNDING 817
OUTSIDE INVESTORS 820
EXITING AN INVESTMENT IN A PRIVATE
COMPANY 822
23.2 THE INITIAL PUBLIC OFFERING 822
ADVANTAGES AND DISADVANTAGES OF
GOING PUBLIC 822
TYPES OF OFFERINGS 823
■ GOOGLE’S IPO 825
THE MECHANICS OF AN IPO 826
IPO PUZZLES 831
CYCLICALITY 833
COST OF AN IPO 834
■ FINANCIAL CRISIS IPO DEALS IN 2008–09 835
LONG-RUN UNDERPERFORMANCE 836
23.3 THE SEASONED EQUITY
OFFERING 837
THE MECHANICS OF AN SEO 837
PRICE REACTION 839
ISSUANCE COSTS 840
SUMMARY 841 KEY TERMS 842
PROBLEMS 842
Chapter 24 Debt Financing 846
24.1 CORPORATE DEBT 847
PUBLIC DEBT 847
PRIVATE DEBT 851
24.2 OTHER TYPES OF DEBT 853
SOVEREIGN DEBT 853
AGENCY SECURITIES 855
PROVINCIAL AND MUNICIPAL BONDS 855
■ FINANCIAL CRISIS SUBPRIME MORTGAGE-BACKED
SECURITIES 856
24.3 BOND COVENANTS 857
24.4 REPAYMENT PROVISIONS 857
CALL PROVISIONS 858
■ NEW YORK CITY CALLS ITS MUNICIPAL
BONDS 858
SINKING FUNDS 862
xviii Contents
CONVERTIBLE PROVISIONS 862
SUMMARY 864 KEY TERMS 866
PROBLEMS 866
Chapter 25 Leasing 868
25.1 THE BASICS OF LEASING 869
EXAMPLES OF LEASE TRANSACTIONS 869
LEASE PAYMENTS AND RESIDUAL VALUES 870
LEASES VERSUS LOANS 871
END-OF-TERM LEASE OPTIONS 872
■ CALCULATING AUTO LEASE PAYMENTS 873
OTHER LEASE PROVISIONS 874
25.2 ACCOUNTING, TAX, AND LEGAL
CONSEQUENCES OF LEASING 875
LEASE ACCOUNTING 875
THE TAX TREATMENT OF LEASES 877
LEASES AND BANKRUPTCY 878
■ SYNTHETIC LEASES 879
Chapter 27 Short-Term Financial
25.3 THE LEASING DECISION 879
CASH FLOWS FOR A TRUE TAX LEASE 880
LEASE VERSUS BUY (AN UNFAIR
COMPARISON) 881
LEASE VERSUS BORROW (THE RIGHT
COMPARISON) 882
EVALUATING A TRUE TAX LEASE 884
EVALUATING A NON-TAX LEASE 886
25.4 REASONS FOR LEASING 886
VALID ARGUMENTS FOR LEASING 887
SUSPECT ARGUMENTS FOR LEASING 889
SUMMARY 890 KEY TERMS 891
PROBLEMS 891
PART 9 SHORT-TERM FINANCING 895
Chapter 26 Working Capital
Management 896
26.1 OVERVIEW OF WORKING CAPITAL 897
THE CASH CYCLE 897
FIRM VALUE AND WORKING CAPITAL 899
26.2 TRADE CREDIT 900
TRADE CREDIT TERMS 900
TRADE CREDIT AND MARKET
FRICTIONS 900
MANAGING FLOAT 902
26.3 RECEIVABLES MANAGEMENT 903
DETERMINING THE CREDIT POLICY 903
MONITORING ACCOUNTS RECEIVABLE 904
26.4 PAYABLES MANAGEMENT 906
DETERMINING ACCOUNTS PAYABLE DAYS
OUTSTANDING 906
STRETCHING ACCOUNTS PAYABLE 907
26.5 INVENTORY MANAGEMENT 908
BENEFITS OF HOLDING INVENTORY 908
COSTS OF HOLDING INVENTORY 908
26.6 CASH MANAGEMENT 909
MOTIVATION FOR HOLDING CASH 910
ALTERNATIVE INVESTMENTS 910
■ FINANCIAL CRISIS CASH BALANCES 912
SUMMARY 912 KEY TERMS 913
PROBLEMS 913
Planning 917
27.1 FORECASTING SHORT-TERM FINANCING
NEEDS 918
SEASONALITIES 918
NEGATIVE CASH FLOW SHOCKS 921
POSITIVE CASH FLOW SHOCKS 921
27.2 THE MATCHING PRINCIPLE 923
PERMANENT WORKING CAPITAL 924
TEMPORARY WORKING CAPITAL 924
FINANCING POLICY CHOICES 925
27.3 SHORT-TERM FINANCING WITH BANK
LOANS 926
SINGLE, END-OF-PERIOD-PAYMENT
LOAN 926
LINE OF CREDIT 926
BRIDGE LOAN 927
COMMON LOAN STIPULATIONS AND FEES 927
27.4 SHORT-TERM FINANCING WITH
COMMERCIAL PAPER 929
27.5 SHORT-TERM FINANCING WITH
SECURED FINANCING 930
ACCOUNTS RECEIVABLE AS COLLATERAL 930
■ FINANCIAL CRISIS SHORT-TERM FINANCING
IN FALL 2008 931
INVENTORY AS COLLATERAL 931
 Contents xix

■ A SEVENTEENTH-CENTURY FINANCING THE FREE-RIDER PROBLEM 961

SOLUTION 932 TOEHOLDS 962
SUMMARY 934 KEY TERMS 934 THE LEVERAGED BUYOUT 963
PROBLEMS 935 ■ THE LEVERAGED BUYOUT OF RJR-NABISCO
BY KKR 964
THE FREEZEOUT MERGER 966
PART 10 SPECIAL TOPICS 939
COMPETITION 967
Chapter 28 Mergers and Acquisitions 940 SUMMARY 967 KEY TERMS 968
PROBLEMS 968
28.1 BACKGROUND AND HISTORICAL
TRENDS 941 Chapter 29 Corporate Governance 971
MERGER WAVES 941
29.1 CORPORATE GOVERNANCE AND
TYPES OF MERGERS 943
AGENCY COSTS 972
28.2 MARKET REACTION TO A
29.2 MONITORING BY THE BOARD OF
TAKEOVER 943
DIRECTORS AND OTHERS 973
28.3 REASONS TO ACQUIRE 944 TYPES OF DIRECTORS 973
ECONOMIES OF SCALE AND SCOPE 945 BOARD INDEPENDENCE 974
VERTICAL INTEGRATION 945 ■ DODD-FRANK ACT 975
EXPERTISE 945 BOARD SIZE AND PERFORMANCE 976
MONOPOLY GAINS 946 OTHER MONITORS 976
EFFICIENCY GAINS 946
29.3 COMPENSATION POLICIES 977
OPERATING LOSSES 947
STOCK AND OPTIONS 977
DIVERSIFICATION 948
PAY AND PERFORMANCE SENSITIVITY 977
EARNINGS GROWTH 949
MANAGER-DRIVEN REASONS TO 29.4 MANAGING AGENCY CONFLICT 979
MERGE 950 DIRECT ACTION BY SHAREHOLDERS 979
CONFLICTS OF INTEREST 951 ■ SHAREHOLDER ACTIVISM AT THE NEW YORK TIMES 980
OVERCONFIDENCE 951 MANAGEMENT ENTRENCHMENT 982
28.4 THE TAKEOVER PROCESS 951 THE THREAT OF TAKEOVER 982

VALUATION 952 29.5 REGULATION 983

THE OFFER 952 THE SARBANES-OXLEY ACT 983
MERGER “ARBITRAGE” 954 ■ INTERVIEW WITH LAWRENCE E. HARRIS 984
TAX AND ACCOUNTING ISSUES 955 THE CADBURY COMMISSION 985
BOARD AND SHAREHOLDER APPROVAL 956 ■ MARTHA STEWART AND IMCLONE 986
28.5 TAKEOVER DEFENCES 957 INSIDER TRADING 987

POISON PILLS 957 29.6 CORPORATE GOVERNANCE AROUND

STAGGERED BOARDS 958 THE WORLD 988
WHITE KNIGHTS 959 PROTECTION OF SHAREHOLDER RIGHTS 988
GOLDEN PARACHUTES 959 CONTROLLING OWNERS AND PYRAMIDS 988
RECAPITALIZATION 959 THE STAKEHOLDER MODEL 990
OTHER DEFENSIVE STRATEGIES 959 CROSS-HOLDINGS 992
REGULATORY APPROVAL 960
29.7 THE TRADEOFF OF CORPORATE
■ WEYERHAEUSER’S HOSTILE BID FOR WILLAMETTE
INDUSTRIES 961
GOVERNANCE 992

28.6 WHO GETS THE VALUE ADDED FROM A SUMMARY 992 KEY TERMS 994
TAKEOVER? 961 PROBLEMS 994
xx Contents
Chapter 30 Risk Management 996
30.1 INSURANCE 997
THE ROLE OF INSURANCE: A SIMPLIFIED
EXAMPLE 997
INSURANCE PRICING IN A PERFECT MARKET 998
THE VALUE OF INSURANCE 999
THE COSTS OF INSURANCE 1002
THE INSURANCE DECISION 1003
30.2 COMMODITY PRICE RISK 1004
HEDGING WITH VERTICAL INTEGRATION AND
STORAGE 1004
HEDGING WITH LONG-TERM CONTRACTS 1005
■ HEDGING STRATEGY LEADS TO PROMOTION …
SOMETIMES 1006
HEDGING WITH FUTURES CONTRACTS 1008
HEDGING WITH OPTIONS CONTRACTS 1011
COMPARING FUTURES HEDGING WITH OPTIONS
HEDGING 1012
DECIDING TO HEDGE COMMODITY
PRICE RISK 1015
■ DIFFERING HEDGING STRATEGIES AT
U.S. AIRLINE 1015
■ COMMON MISTAKE HEDGING RISK 1016
30.3 EXCHANGE RATE RISK 1017
EXCHANGE RATE FLUCTUATIONS 1017
HEDGING WITH FORWARD CONTRACTS 1019
CASH-AND-CARRY AND THE PRICING OF
CURRENCY FORWARDS 1020
HEDGING WITH OPTIONS 1024
30.4 INTEREST RATE RISK 1028
INTEREST RATE RISK MEASUREMENT:
DURATION 1029
DURATION-BASED HEDGING 1031
■ THE SAVINGS AND LOAN CRISIS 1033
SWAP-BASED HEDGING 1035
SUMMARY 1039 KEY TERMS 1040
PROBLEMS 1041
Chapter 31 International Corporate
Finance 1048
31.1 INTERNATIONALLY INTEGRATED
CAPITAL MARKETS 1049
31.2 VALUATION OF FOREIGN CURRENCY
CASH FLOWS 1051
WACC VALUATION METHOD IN DOMESTIC
CURRENCY 1051
USING THE LAW OF ONE PRICE AS A ROBUSTNESS
CHECK 1054
31.3 VALUATION AND INTERNATIONAL
TAXATION 1055
SINGLE FOREIGN PROJECT WITH IMMEDIATE
REPATRIATION OF EARNINGS 1055
MULTIPLE FOREIGN PROJECTS AND DEFERRAL OF
EARNINGS REPATRIATION 1056
31.4 INTERNATIONALLY SEGMENTED
CAPITAL MARKETS 1057
DIFFERENTIAL ACCESS TO MARKETS 1057
MACRO-LEVEL DISTORTIONS 1057
IMPLICATIONS 1058
31.5 CAPITAL BUDGETING WITH
EXCHANGE RISK 1060
■ INTERVIEW WITH BILL BARRETT 1063
SUMMARY 1064 KEY TERMS 1064
PROBLEMS 1065
GLOSSARY G-1
INDEX I-1
About the Authors
Peter DeMarzo and Jonathan Berk
JONATHAN BERK is the A.P. Giannini Professor of Finance at the Graduate School
of Business, Stanford University and is a Research Associate at the National Bureau
of Economic Research. Before coming to Stanford, he was the Sylvan Coleman
Professor of Finance at Haas School of Business at the University of California,
Berkeley. Prior to earning his Ph.D., he worked as an Associate at Goldman Sachs
(where his education in finance really began).
Professor Berk’s research interests in finance include corporate valuation, capital
structure, mutual funds, asset pricing, experimental economics, and labor economics.
His work has won a number of research awards including the TIAA-CREF Paul A.
Samuelson Award, the Smith Breeden Prize, Best Paper of the Year in The Review
of Financial Studies, and the FAME Research Prize. His paper, “A Critique of Size-
Related Anomalies,” was selected as one of the two best papers ever published in
The Review of Financial Studies. In recognition of his influence on the practice of
finance he has received the Bernstein-Fabozzi/Jacobs Levy Award, the Graham and
Dodd Award of Excellence, and the Roger F. Murray Prize. He served as an Associate
Editor of the Journal of Finance for eight years and is currently an Advisory Editor
of the journal.
Born in Johannesburg, South Africa, Professor Berk is married, with two daugh-
ters, and is an avid skier and biker.
PETER DEMARZO is the Mizuho Financial Group Professor of Finance and Senior
Associate Dean for Academic Affairs at the Stanford Graduate School of Business.
He is also a Research Associate at the National Bureau of Economic Research.
He currently teaches MBA and Ph.D. courses in Corporate Finance and Financial
Modelling. In addition to his experience at the Stanford Graduate School of Busi-
ness, Professor DeMarzo has taught at the Haas School of Business and the Kellogg
Graduate School of Management, and he was a National Fellow at the Hoover
Institution.
Professor DeMarzo received the Sloan Teaching Excellence Award at Stanford in
2004 and 2006, and the Earl F. Cheit Outstanding Teaching Award at U.C. Berkeley
in 1998. Professor DeMarzo has served as an Associate Editor for The Review of
Financial Studies, Financial Management, and the B.E. Journals in Economic Analysis
and Policy, as well as a Director of the American Finance Association. He has served
as Vice President and is currently President-elect of the Western Finance Associa-
tion. Professor DeMarzo’s research is in the area of corporate finance, asset securiti-
zation, and contracting, as well as market structure and regulation. His recent work
has examined issues of the optimal design of contracts and securities, the regulation
of insider trading and broker-dealers, and the influence of information asymmetries
on corporate investment. He has received numerous awards including the Western
Finance Association Corporate Finance Award and the Barclays Global Investors/
Michael Brennan best-paper award from The Review of Financial Studies.
Professor DeMarzo was born in Whitestone, New York, and is married with
three boys. He and his family enjoy hiking, biking, and skiing.
xxii About the Authors

DAVID STANGELAND, PhD, BComm (Distinction), CMA, did his undergraduate

and graduate university education at the University of Alberta in Edmonton. In 1991,
he moved to Winnipeg where he joined the Accounting & Finance Department in
the I. H. Asper School of Business at the University of Manitoba. Dr. Stangeland is a
Professor of Finance, was Head of the Department of Accounting & Finance for two
terms, was Acting Head of the Department of Economics for two years, and is the
Associate Dean of the I. H. Asper School of Business responsible for Undergraduate
and MBA programs and Faculty administration.
Professor Stangeland teaches finance courses at the University of Manitoba and
in the Canadian Executive MBA program at the Warsaw School of Economics in
Poland. His teaching spans undergraduate, MBA, and Ph.D. courses in corporate
finance, investment banking, and international finance.
Professor Stangeland’s research interests are in the areas of corporate governance,
David Stangeland corporate control, and corporate finance. His work is well cited and has been pub-
lished in several journals including the Journal of Financial and Quantitative Analysis,
the Journal of Banking & Finance, the Journal of Corporate Finance, Financial Manage-
ment, the Stanford Journal of Law, Business, & Finance, and numerous others.
Dr. Stangeland served on the National Board of Directors of CMA Canada and
he chaired CMA Canada’s Pension Committee. He was a member of the Board of
Trustees for the University of Manitoba Pension Plans and a member of the Pen-
sion Committee for the University of Manitoba. He is a member of the Investment
Committee for the Teachers Retirement Allowance Fund, and served on the Inde-
pendent Review Committee for two mutual fund companies. Professor Stangeland
is a two-time recipient of the CMA Canada Academic Merit Award for Teaching
and Research, a four-time winner of the University of Manitoba Teaching Services
Award, and a recipient of the Associates Award for Research.
Professor Stangeland was born and raised in Edmonton, Alberta, where he
learned to appreciate the outdoors including running, cycling, hiking, and skiing
and, in the winter, travelling to warmer climates.
Preface
The first Canadian edition was written just as the financial crisis of 2008–2009 was unfold-
ing. One thing that was reinforced by the financial crisis and the continuing crises that
followed is the need to understand finance so that correct decision making is done. As we
said in the first edition, understanding finance is important and is the purpose of this book:
In our over 50 years of combined teaching experience, we have found that leaving out core
material deemed “too hard” actually makes the subject matter less accessible. The core concepts in
finance are simple and intuitive. What makes the subject challenging is that it is often difficult
for a novice to distinguish between these core ideas and other intuitively appealing approaches
that, if used in financial decision making, will lead to incorrect decisions. De-emphasizing the
core concepts that underlie finance strips students of the essential intellectual tools they need to dif-
ferentiate between good and bad decision making. Therefore, our primary motivation for writing
this book was to equip students with a solid grounding in the core financial concepts and tools
needed to make good decisions.
There is little doubt that one of the most important contributing factors to the financial
crisis was that many practitioners who should have known better did not understand, or
chose to ignore, the core concepts that underlie finance in general (and the pedagogy in this
book in particular), leading them to make many very bad decisions.
We present corporate finance as an application of a set of simple, powerful ideas. At the
heart is the principal of the absence of arbitrage opportunities, or Law of One Price: In life,
you don’t get something for nothing. This simple concept is a powerful and important tool
in financial decision making. By relying on it, and the other core principles in this book,
financial decision makers can avoid the bad decisions brought to light by the financial crisis.
We use the Law of One Price as a compass; it keeps financial decision makers on the right
track and is the backbone of the entire book.

NEW TO THIS EDITION

We have updated all text discussions and figures, tables, and facts to accurately reflect
developments in the field in the last three years. Given the success of the first two editions,
we focused substantive changes on areas where there was clear evidence that such change
would be beneficial. Specific highlights include the following:
• As painful as the financial crisis was, there is a silver lining: it provides a valuable peda-
gogical illustration of what can go wrong when practitioners ignore the core concepts
that underlie financial decision making. We integrate this important lesson into the book
in a series of contextual boxes we call Financial Crisis boxes.
• Chapter 3 – Arbitrage and Financial Decision Making has undergone several important
changes:
• We moved the appendix material into the body of the chapter because of feedback
indicating the material on the price of risk was useful to understand early in the text.
• We introduced primitive securities so that instructors could set up easier replicating-
portfolio questions that do not require the more complicated math.
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 Wherever he sojourned, dance and song fled;—the former he
accounted a devoting of limbs which God made to the worship of
Satan; the latter he believed to be a sinful meting out of wanton
words to a heathen measure. Satan, he said, leaped and danced, and
warbled and sung, when he came to woo to perdition the giddy sons
and daughters of men. He dictated the colour and the cut of men’s
clothes—it was seemly for those who sought salvation to seek it in a
sober suit; and the ladies of his parish were obliged to humble their
finery, and sober down their pride, before his sarcastic sermons on
female paintings, and plumings, and perfumings, and the
unloveliness of love-locks. He sought to make a modest and sedate
grace abound among women; courtship was schooled and sermoned
into church controversy, and love into mystical professions; the
common civilities between the sexes were doled out with a suspicious
hand and a jealous charity, and the primrose path through the groves
of dalliance to the sober vale of marriage was planted with thorns
and sown with briars.
He had other endowments not uncommon among the primitive
teachers of the Word. In his day, the empire of the prince of darkness
was more manifest among men than now, and his ministry was
distinguished, like the reign of King Saul, by the persecution of
witches, and elves, and evil spirits. He made himself the terror of all
those who dealt in divinations, or consulted the stars, or sought to
avert witchcraft by sinful spell and charm, instead of overcoming it
by sorrowings and spiritual watchings. The midnight times of
planetary power he held as the prime moments of Satan’s glory on
earth, and he punished Hallowmas revellers as chief priests in the
infernal rites. He consigned to church censure and the chastening of
rods a wrinkled dame who sold a full sea and a fair wind to mariners,
and who insulted the apostles, and made a mystical appeal to the
twelve signs of heaven in setting a brood goose with a dozen eggs.
His wrath, too, was observed to turn against all those who
compounded with witches, and people who carried evil influence in
their eyes—this was giving tribute to the fiend, and bribing the
bottomless pit.
He rebuked the venerable dame, during three successive Sundays,
for placing a cream bowl and new-baked cake in the paths of the
nocturnal elves who, she imagined, had plotted to steal her grandson
from the mother’s bosom. He turned loose many Scripture
threatenings against those diminutive and capricious beings, the
fairies, and sought to preach them from the land. He prayed on every
green hill, and held communings in every green valley. He wandered
forth at night, as a spiritual champion, to give battle to the enemies
of the light. The fairies resigned the contest with a foe equipped from
such an armoury, and came no more among the sons and daughters
of men. The sound of their minstrelsy ceased on the hill; their
equestrian processions were seen no more sweeping past at midnight
beneath the beam of the half-filled moon; and only a solitary and
sullen elf or two remained to lament the loss of their immemorial
haunts. With the spirits of evil men and the lesser angels of darkness
he waged a fierce and dubious war; he evoked an ancient ghost from
a ruined tower, which it had shared for generations with the owl; and
he laid or tranquillized a fierce and troubled spirit which had
haunted the abode of a miser in a neighbouring churchyard, and
seemed to gibber and mumble over his bones. All these places were
purified by prayer, and hallowed by the blessing of the gifted pastor
Ezra Peden.
The place of his ministry seemed fitted by nature, and largely
endowed by history, for the reception and entertainment of all
singular and personified beliefs. Part was maritime, and part
mountainous, uniting the aërial creeds of the shepherds with the
stern and more imposing beliefs of the husbandman, and the wild
and characteristic superstitions of the sailors. It often happened,
when he had marched against and vanquished a sin or a superstition
of native growth, he was summoned to wage war with a new foe; to
contend with a legion of errors, and a strange race of spirits from the
haunted coasts of Norway or Sweden. All around him on every side
were records of the mouldering influence of the enemies of faith and
charity. On the hill where the heathen Odin had appeared to his
worshippers in the circle of granite, the pillars of his Runic temple
promised to be immortal; but the god was gone, and his worship was
extinct. The sword, the spear, and the banner, had found sanctuary
from fields of blood on several lofty promontories; but shattered
towers and dismantled castles told that for a time hatred, oppression,
and revenge had ceased to triumph over religion. Persecution was
now past and gone, a demon exorcised by the sword had hallowed
three wild hills and sanctified two little green valleys with the blood
of martyrs. Their gravestones, bedded among heather or long grass,
cried up to heaven against their oppressors in verses which could not
surely fail to elude the punishment awarded by the Kirk against
poesy. Storms, and quicksands, and unskilful mariners, or, as
common belief said, the evil spirits of the deep, had given to the
dangerous coast the wrecks of three stately vessels; and there they
made their mansions, and raised whirlwinds, and spread quicksands,
and made sandbanks, with a wicked diligence, which neither prayer
nor preaching could abate. The forms under which these restless
spirits performed their pranks have unfortunately been left
undefined by a curious and poetical peasantry.
It happened one winter, during the fifteenth year of the ministry of
Ezra Peden, and in the year of grace 1705, that he sat by his fire
pondering deep among the treasures of the ancient Presbyterian
worthies, and listening occasionally to the chafing of the coming tide
against cliff and bank, and the fitful sweep of heavy gusts of wind
over the roof of his manor. During the day he had seemed more
thoughtful than usual; he had consulted Scripture with an anxious
care, and fortified his own interpretation of the sacred text by the
wisdom of some of the chiefs and masters of the calling. A Bible, too,
bound in black oak, and clasped with silver, from the page of which
sin had received many a rebuke, and the abominations of witchcraft
and sorcery had been cleansed from the land, was brought from its
velvet sanctuary and placed beside him. Thus armed and prepared,
he sat like a watcher of old on the towers of Judah; like one who
girds up his loins and makes bare his right arm for some fierce and
dubious contest.
All this stir and preparation passed not unnoticed of an old man,
his predecessor’s coeval, and prime minister of the household; a
person thin, religious, and faithful, whose gifts in prayer were
reckoned by some old people nearly equal to those of the anointed
pastor. To such a distinction Josiah never thought of aspiring; he
contented himself with swelling the psalm into something like
melody on Sunday; visiting the sick as a forerunner of his master’s
approach, and pouring forth prayers and graces at burials and
banquetings, as long and dreary as a hill sermon. He looked on the
minister as something superior to man; a being possessed by a divine
spirit; and he shook his head with all its silver hairs, and uttered a
gentle groan or two, during some of the more rapt and glowing
passages of Ezra’s sermons.
This faithful personage stood at the door of his master’s chamber,
unwilling to go in, and yet loath to depart. “Josiah, thou art called,
Josiah,” said Ezra, in a grave tone, “so come hither; the soul of an evil
man, a worker of iniquity, is about to depart; one who drank the
blood of saints, and made himself fat with the inheritance of the
righteous. It hath been revealed to me that his body is sorely
troubled; but I say unto you, he will not go from the body without the
strong compulsion of prayer, and therefore am I summoned to war
with the enemy; so I shall arm me to the task.”
Josiah was tardy in speech, and before he could reply, the clatter of
a horse’s hoofs was heard at the gate: the rider leapt down, and,
splashed with mire and sprinkled with sleet, he stood in an instant
before the minister.
“Ah, sir,” said the unceremonious messenger, “haste! snatch up the
looms of redemption, and bide not the muttering of prayer, else auld
Mahoun will have his friend Bonshaw to his cauldron, body and soul,
if he hasna him half-way hame already. Godsake, sir, start and fly,
for he cannot shoot over another hour! He talks of perdition, and
speaks about a broad road and a great fire, and friends who have
travelled the way before him. He’s no his lane, however,—that’s one
comfort; for I left him conversing with an old cronie, whom no one
saw but himself—one whose bones are ripe and rotten; and mickle
they talked of a place called Tophet,—a hot enough region, if one can
credit them; but I aye doubt the accounts of such travellers,—they are
like the spies of the land of promise”——
“Silence thine irreverent tongue, and think of thy latter end with
fear and trembling,” said Ezra, in a stern voice. “Mount thy horse,
and follow me to the evil man, thy master; brief is the time, and black
is the account, and stern and inexorable will the summoning angel
be.”
And leaping on their horses, they passed from the manse, and
sought out the bank of a little busy stream, which, augmented by a
fall of sleet, lifted up a voice amid its rocky and desolate glen equal to
the clamour of a mightier brook. The glen or dell was rough with
sharp and projecting crags, which, hanging forward at times from
opposite sides, seemed to shut out all further way; while from
between their dark-gray masses the rivulet leapt out in many divided
streams. The brook again gathered together its waters, and subsided
into several clear deep pools, on which the moon, escaping for a
moment from the edge of a cloud of snow, threw a cold and wavering
gleam. Along the sweeps of the stream a rough way, shaped more by
nature than by the hand of man, winded among the rocks; and along
this path proceeded Ezra, pondering on the vicissitudes of human
life.
At length he came where the glen expanded, and the sides became
steep and woody; amid a grove of decaying trees, the mansion of
Bonshaw rose, square and gray. Its walls of rough granite were high
and massive; the roof, ascending steep and sharp, carried a covering
of red sandstone flags; around the whole the rivulet poured its scanty
waters in a deep moat, while a low-browed door, guarded by
loopholes, gave it the character of a place of refuge and defence.
Though decayed and war-worn now, it had, in former times, been a
fair and courtly spot. A sylvan nook or arbour, scooped out of the
everlasting rock, was wreathed about with honeysuckle; a little pool,
with a margin studded with the earliest primroses, lay at its
entrance; and a garden, redeemed by the labour of man from the
sterile upland, had its summer roses and its beds of lilies, all bearing
token of some gentle and departed inhabitant.
As he approached the house, a candle glimmered in a small square
window, and threw a line or two of straggling light along the path. At
the foot of the decayed porch he observed the figure of a man
kneeling, and presently he heard a voice chanting what sounded like
a psalm or a lyke-wake hymn. Ezra alighted and approached,—the
form seemed insensible of his presence, but stretched his hands
towards the tower; and while the feathery snow descended on his
gray hair, he poured his song forth in a slow and melancholy
manner.
“I protest,” said the messenger, “here kneels old William Cameron,
the Covenanter. Hearken, he pours out some odd old-world malison
against Bonshaw. I have heard that the laird hunted him long and
sore in his youth, slew his sons, burned his house, threw his two
bonny daughters desolate,—that was nae gentle deed, however,—and
broke the old mother’s heart with downright sorrow. Sae I canna
much blame the dour auld carle for remembering it even now,
though the candles of Bonshaw are burning in the socket, and his
light will soon be extinguished for ever. Let us hearken to his psalm
or his song; it is no every night we have minstrelsy at Bonshaw gate, I
can tell ye that.”
The following are the verses, which have been preserved under the
title of “Ane godly exultation of William Cameron, a chosen vessel,
over Bonshaw, the persecutor.” I have adopted a plainer, but a less
descriptive title—
THE DOWNFALL OF DALZELL.

I.

The wind is cold, the snow falls fast,

The night is dark and late,
As I lift aloud my voice and cry
By the oppressor’s gate.
There is a voice in every hill,
A tongue in every stone;
The greenwood sings a song of joy,
Since thou art dead and gone;
A poet’s voice is in each mouth,
And songs of triumph swell,
Glad songs, that tell the gladsome earth
The downfall of Dalzell.

II.

As I raised up my voice to sing,

I heard the green earth say,
Sweet am I now to beast and bird,
Since thou art passed away:
I hear no more the battle shout,
The martyrs’ dying moans;
My cottages and cities sing
From their foundation-stones;
The carbine and the culverin’s mute,—
The death-shot and the yell
Are turned into a hymn of joy,
For thy downfall, Dalzell

III.

I’ve trod thy banner in the dust,

 And caused the raven call
From thy bride-chamber to the owl
Hatched on thy castle wall;
I’ve made thy minstrels’ music dumb,
And silent now to fame
Art thou, save when the orphan casts
His curses on thy name.
Now thou may’st say to good men’s prayers
A long and last farewell:
There’s hope for every sin save thine,—
Adieu, adieu, Dalzell!

IV.

The grim pit opes for thee her gates,

Where punished spirits wail,
And ghastly Death throws wide his door,
And hails thee with a Hail.
Deep from the grave there comes a voice,
A voice with hollow tones,
Such as a spirit’s tongue would have
That spoke through hollow bones:—
“Arise, ye martyred men, and shout
From earth to howling hell;
He comes, the persecutor comes!
All hail to thee, Dalzell!”

V.

O’er an old battle-field there rushed

A wind, and with a moan
The severed limbs all rustling rose,
Even fellow bone to bone.
“Lo! there he goes,” I heard them cry,
“Like babe in swathing band,
Who shook the temples of the Lord,
And passed them ’neath his brand.
Cursed be the spot where he was born,
There let the adders dwell,
And from his father’s hearthstone hiss:
All hail to thee, Dalzell!”

VI.

I saw thee growing like a tree,—

Thy green head touched the sky,—
But birds far from thy branches built,
The wild deer passed thee by;
No golden dew dropt on thy bough,
Glad summer scorned to grace
Thee with her flowers, nor shepherds wooed
Beside thy dwelling-place;
The axe has come and hewed thee down,
Nor left one shoot to tell
Where all thy stately glory grew:
Adieu, adieu, Dalzell!

VII.

An ancient man stands by thy gate,

His head like thine is gray;
Gray with the woes of many years,
Years fourscore and a day.
Five brave and stately sons were his;
Two daughters, sweet and rare;
An old dame, dearer than them all,
And lands both broad and fair;—
Two broke their hearts when two were slain,
And three in battle fell,—
An old man’s curse shall cling to thee,—
Adieu, adieu, Dalzell!

VIII.

And yet I sigh to think of thee,

A warrior tried and true
As ever spurred a steed, when thick
The splintering lances flew.
I saw thee in thy stirrups stand,
And hew thy foes down fast,
When Grierson fled, and Maxwell failed,
And Gordon stood aghast;
And Graeme, saved by thy sword, raged fierce
As one redeemed from hell.
I came to curse thee,—and I weep:
So go in peace, Dalzell!

When this wild and unusual hymn concluded, the Cameronian

arose and departed, and Ezra and his conductor entered the chamber
of the dying man.
 He found him stretched on a couch of state, more like a warrior cut
in marble than a breathing being. He had still a stern and martial
look, and his tall and stalwart frame retained something of that
ancient exterior beauty for which his youth was renowned. His
helmet, spoiled by time of its plumage, was placed on his head; a
rusty corslet was on his bosom; in his arms, like a bride, lay his broad
and famous sword; and as he looked at it, the battles of his youth
passed in array before him. Armour and arms hung grouped along
the walls, and banners, covered with many a quaint and devotional
device, waved in their places as the domestic closed the door on Ezra
and the dying warrior in the chamber of presence.
The devout man stood and regarded his ancient parishioner with a
meek and sorrowful look; but nothing visible or present employed
Bonshaw’s reflections or moved his spirit—his thoughts had
wandered back to earlier years, and to scenes of peril and blood. He
imagined himself at the head of his horsemen in the hottest period of
the persecution, chasing the people from rock to rock, and from glen
to cavern. His imagination had presented to his eye the destruction
of the children of William Cameron. He addressed their mother in a
tone of ironical supplication,—
“Woman, where is thy devout husband, and thy five holy sons? Are
they busied in interminable prayers or everlasting sermons? Whisper
it in my ear, woman,—thou hast made that reservation doubtless in
thy promise of concealment. Come, else I will wrench the truth out of
thee with these gentle catechists, the thumbscrew and the bootikin.
Serving the Lord, sayest thou, woman? Why, that is rebelling against
the king. Come, come, a better answer, else I shall make thee a bride
for a saint on a bloody bed of heather!
Here he paused and waved his hand like a warrior at the head of
armed men, and thus he continued,—
“Come, uncock thy carbine, and harm not the woman till she hear
the good tidings. Sister saint, how many bairns have ye? I bless God,
saith she, five—Reuben, Simon, Levi, Praisegod, and Patrick. A
bonny generation, woman. Here, soldier, remove the bandages from
the faces of those two young men before ye shoot them. There stands
Patrick, and that other is Simon;—dost thou see the youngest of thy
affections? The other three are in Sarah’s bosom—thyself shall go to
Abraham’s. The woman looks as if she doubted me;—here, toss to her
those three heads—often have they lain in her lap, and mickle have
they prayed in their time. Out, thou simpleton! canst thou not
endure the sight of the heads of thine own fair-haired sons, the smell
of powder, and the flash of a couple of carbines?”
The re-acting of that ancient tragedy seemed to exhaust for a little
while the old persecutor. He next imagined himself receiving the
secret instructions of the Council.
“What, what, my lord, must all this pleasant work fall to me? A
reeking house and a crowing cock shall be scarce things in Nithsdale.
Weepings and wailings shall be rife—the grief of mothers, and the
moaning of fatherless babes. There shall be smoking ruins and
roofless kirks, and prayers uttered in secret, and sermons preached
at a venture and a hazard on the high and solitary places. Where is
General Turner?—Gone where the wine is good?—And where is
Grierson?—Has he begun to talk of repentance?—Gordon thinks of
the unquenchable fire which the martyred Cameronian raved about;
and gentle Graeme vows he will cut no more throats unless they wear
laced cravats. Awell, my lords; I am the king’s servant, and not
Christ’s, and shall boune me to the task.”
His fancy flew over a large extent of time, and what he uttered now
may be supposed to be addressed to some invisible monitor; he
seemed not aware of the presence of the minister.
“Auld, say you, and gray-headed, and the one foot in the grave; it is
time to repent, and spice and perfume over my rottenness, and
prepare for heaven? I’ll tell ye, but ye must not speak on’t—I tried to
pray late yestreen—I knelt down, and I held up my hands to heaven—
and what think ye I beheld? a widow woman and her five fair sons
standing between me and the Most High, and calling out, ‘Woe, woe,
on Bonshaw.’ I threw myself with my face to the earth, and what got I
between my hands? A gravestone which covered five martyrs, and
cried out against me for blood which I had wantonly shed. I heard
voices from the dust whispering around me; and the angel which
watched of old over the glory of my house hid his face with his hands,
and I beheld the evil spirits arise with power to punish me for a
season. I’ll tell ye what I will do—among the children of those I have
slain shall my inheritance be divided; so sit down, holy sir, and sit
down, most learned man, and hearken to my bequest. To the
children of three men slain on Irongray Moor—to the children of two
slain on Closeburn-hill—to—no, no, no, all that crowd, that
multitude, cannot be the descendants of those whom I doomed to
perish by the rope, and the pistol, and the sword. Away, I say, ye
congregation of zealots and psalm-singers!—disperse, I say, else I
shall trample ye down beneath my horse’s hoofs! Peace, thou
whiteheaded stirrer of sedition, else I shall cleave thee to the collar!—
wilt thou preach still?”
Here the departing persecutor uttered a wild imprecation,
clenched his teeth, leaped to his feet, waved his sword, and stood for
several moments, his eyes flashing from them a fierce light, and his
whole strength gathered into a blow which he aimed at his imaginary
adversary. But he stiffened as he stood—a brief shudder passed over
his frame, and he was dead before he fell on the floor, and made the
hall re-echo.
The minister raised him in his arms—a smile of military joy still
dilated his stern face—and his hand grasped the sword hilt so firmly
that it required some strength to wrench it from his hold. Sore, sore
the good pastor lamented that he had no death-bed communings
with the departed chief, and he expressed this so frequently, that the
peasantry said, on the day of his burial, that it would bring back his
spirit to earth and vex mankind, and that Ezra would find him
particularly untractable and bold. Of these whisperings he took little
heed, but he became somewhat more grave and austere than usual.
 Chapter II.

It happened on an evening about the close of the following spring,

when the oat braird was flourishing, and the barley shot its sharp
green spikes above the clod, carrying the dew on the third morning,
that Ezra Peden was returning from a wedding at Buckletiller. When
he left the bridal chamber it was about ten o’clock. His presence had
suppressed for a time the natural ardour for dancing and mirth
which characterises the Scotch; but no sooner was he mounted, and
the dilatory and departing clatter of his horse’s hoofs heard, than
musicians and musical instruments appeared from their hiding-
places. The floor was disencumbered of the bridal dinner-tables, the
maids bound up their long hair, and the hinds threw aside their
mantles, and, taking their places and their partners, the restrained
mirth broke out like a whirlwind. Old men looked on with a sigh, and
uttered a feeble and faint remonstrance, which they were not
unwilling should be drowned in the abounding and augmenting
merriment.
The pastor had reached the entrance of a little wild and seldom
frequented glen, along which a grassy and scarce visible road winded
to an ancient burial-ground. Here the graceless and ungodly
merriment first reached his ears, and made the woody hollow ring
and resound. Horse and rider seemed possessed of the same spirit—
the former made a full halt when he heard the fiddle note, while the
latter, uttering a very audible groan, and laying the bridle on his
horse’s neck, pondered on the wisest and most effectual way of
repressing this unseemly merriment—of cleansing the parish of this
ancient abomination. It was a beautiful night; the unrisen moon had
yet a full hour of travel before she could reach the tops of the eastern
hills; the wind was mute, and no sound was abroad save the chafing
of a small runnel, and the bridal mirth.
While Ezra sat casting in his own mind a long and a dubious
contest with this growing and unseemly sin, something like the
shadowy outline of a horse and rider appeared in the path. The night
was neither light nor dark, and the way, grassy and soft, lay broad
and uninterrupted between two hazel and holly groves. As the pastor
lifted up his eyes, he beheld a dark rider reining up a dark horse side
by side with his own, nor did he seem to want any accoutrement
necessary for ruling a fine and intractable steed. As he gazed, the
figure became more distinct; it seemed a tall martial form, with a
slouched hat and feather, and a dark and ample mantle, which was
muffled up to his eyes. From the waist downward all was indistinct,
and horse and rider seemed to melt into one dark mass visible in the
outline alone. Ezra was too troubled in spirit to court the intrusion of
a stranger upon his meditations; he bent on him a look particularly
forbidding and stern, and having made up his mind to permit the
demon of mirth and minstrelsy to triumph for the present, rode
slowly down the glen.
But side by side with Ezra, and step by step, even as shadow
follows substance, moved the mute and intrusive stranger. The
minister looked at his companion, and stirred his steed onward; with
corresponding speed moved the other, till they came where the road
branched off to a ruined castle. Up this way, with the wish to avoid
his new friend, Ezra turned his horse; the other did the same. The
former seemed suddenly to change his mind, and returned to the
path that led to the old burial-ground; the latter was instantly at his
side, his face still hidden in the folds of his mantle.
Now, Ezra was stern and unaccommodating in kirk controversy,
and the meek and gentle spirit of religion, and a sense of spiritual
interest, had enough to do to appease and sober down a temper
naturally bold, and even warlike. Exasperated at this intruding
stranger, his natural triumphed over his acquired spirit, and lifting
his riding-stick, and starting up in his stirrups, he aimed a blow
equal to the unhorsing of any ordinary mortal. But the weapon met
with no obstruction—it seemed to descend through air alone. The
minister gazed with dread on this invulnerable being; the stranger
gazed on him; and both made a halt like men preparing for mortal
fray. Ezra, who felt his horse shuddering beneath him, began to
suspect that his companion pertained to a more dubious state of
existence than his own, and his grim look and sable exterior induced
him to rank him at once among those infamous and evil spirits which
are sometimes permitted to trouble the earth, and to be a torment to
the worthy and the devout.
 He muttered a brief and pithy prayer, and then said,—
“Evil shape, who art thou, and wherefore comest thou unto me? If
thou comest for good, speak; if for my confusion and my harm, even
do thine errand; I shall not fly from thee.”
“I come more for mine own good than for thy harm,” responded
the figure. “Far have I ridden, and much have I endured, that I might
visit thee and this land again.”
“Do you suffer in the flesh, or are you tortured in the spirit?” said
the pastor, desirous to know something certain of his unwelcome
companion.
“In both,” replied the form. “I have dwelt in the vale of fire, in the
den of punishment, hollow, and vast, and dreadful; I have ridden
through the region of snow and the land of hail; I have swam through
the liquid wilderness of burning lava,—passed an illimitable sea, and
all for the love of one hour of this fair green earth, with its fresh airs
and its new-sprung corn.”
Ezra looked on the figure with a steady and a penetrating eye. The
stranger endured the scrutiny.
“I must know of a truth to whom and what I speak—I must see you
face to face. Thou mayest be the grand artificer of deceit come to
practise upon my immortal soul. Unmantle thee, I pray, that I may
behold if thou art a poor and an afflicted spirit punished for a time,
or that fierce and restless fiend who bears the visible stamp of eternal
reprobation.”
“I may not withstand thy wish,” muttered the form in a tone of
melancholy, and dropping his mantle, and turning round on the
pastor, said, “Hast thou forgotten me?”
“How can I forget thee?” said Ezra, receding as he spoke. “The
stern and haughty look of Bonshaw has been humbled indeed.
Unhappy one, thou art sorely changed since I beheld thee on earth
with the helmet-plume fanning thy hot and bloody brow as thy right
hand smote down the blessed ones of the earth! The Almighty doom
—the evil and the tormenting place—the vile companions—have each
in their turn done the work of retribution upon thee; thou art indeed
more stern and more terrible, but thou art not changed beyond the
knowledge of one whom thou hast hunted and hounded, and sought
to slay utterly.”
 The shape or spirit of Bonshaw, dilated with anger, and in a
quicker and fiercer tone, said—
“Be charitable; flesh and blood, be charitable. Doom not to hell-
fire and grim companions one whose sins thou canst not weigh but in
the balance of thine own prejudices. I tell thee, man of God, the
uncharitableness of the sect to which thou pertainest has thronged
the land of punishment as much as those who headed, and hanged,
and stabbed, and shot, and tortured. I may be punished for a time,
and not wholly reprobate.”
“Punished in part, or doomed in whole, thou needs must be,”
answered the pastor, who seemed now as much at his ease as if this
singular colloquy had happened with a neighbouring divine. “A holy
and a blessed spirit would have appeared in a brighter shape. I like
not thy dubious words, thou half-punished and half-pardoned spirit.
Away, vanish! shall I speak the sacred words which make the fiends
howl, or wilt thou depart in peace?”
“In peace I come to thee,” said the spirit, “and in peace let me be
gone. Hadst thou come sooner when I summoned thee, and not
loitered away the precious death-bed moments, hearkening the wild
and fanciful song of one whom I have deeply wronged, this journey
might have been spared—a journey of pain to me, and peril to
thyself.”
“Peril to me!” said the pastor; “be it even as thou sayest. Shall I fly
for one cast down, over whose prostrate form the purging fire has
passed? Wicked was thy course on earth—many and full of evil were
thy days—and now thou art loose again, thou fierce and persecuting
spirit,—a woe, and a woe to poor Scotland!”
“They are loose who never were bound,” answered the spirit of
Bonshaw, darkening in anger, and expanding in form, “and that I
could soon show thee. But, behold, I am not permitted;—there is a
watcher—a holy one come nigh prepared to resist and to smite. I
shall do thee no harm, holy man—I vow by the pains of punishment
and the conscience-pang—now the watcher has departed.”
“Of whom speakest thou?” inquired Ezra. “Have we ministering
spirits who guard the good from the plots of the wicked ones? Have
we evil spirits who tempt and torment men, and teach the maidens
ensnaring songs, and lighten their feet and their heads for the
wanton dance?”
“Stay, I pray thee,” said the spirit; “there are spirits of evil men and
of good men made perfect, who are permitted to visit the earth, and
power is given them for a time to work their will with men. I beheld
one of the latter even now, a bold one and a noble; but he sees I
mean not to harm thee, so we shall not war together.”
At this assurance of protection, the pastor inclined his shuddering
steed closer to his companion, and thus he proceeded:—
“You have said that my sect—my meek and lowly, and broken, and
long persecuted remnant—have helped to people the profound hell;
am I to credit thy words?”
“Credit them or not as thou wilt,” said the spirit; “whoso spilleth
blood by the sword, by the word, and by the pen, is there: the false
witness; the misinterpreter of the Gospel; the profane poet; the
profane and presumptuous preacher; the slayer and the slain; the
persecutor and the persecuted; he who died at the stake, and he who
piled the faggot;—all are there, enduring hard weird and penal fire
for a time reckoned and days numbered. They are there whom thou
wottest not of,” said the confiding spirit, drawing near as he spoke,
and whispering the names of some of the worthies of the Kirk, and
the noble, and the far-descended.
“I well believe thee,” said the pastor; “but I beseech thee to be
more particular in thy information: give me the names which some
of the chief ministers of woe in the nether world were known by in
this. I shall hear of those who built cathedrals and strongholds, and
filled thrones spiritual and temporal.”
“Ay, that thou wilt,” said the spirit, “and the names of some of the
mantled professors of God’s humble Presbyterian Kirk also; those
who preached a burning fire and a devouring hell to their dissenting
brethren, and who called out with a loud voice, ‘Perdition to the sons
and daughters of men; draw the sword; slay and smite utterly.’”
“Thou art a false spirit assuredly,” said the pastor; “yet tell me one
thing. Thy steed and thou seem to be as one, to move as one, and I
observed thee even now conversing with thy brute part; dost thou
ride on a punished spirit, and is there injustice in hell as well as on
earth?”
 The spirit laughed.
“Knowest thou not this patient and obedient spirit on whom I
ride?—what wouldst thou say if I named a name renowned at the
holy altar? the name of one who loosed the sword on the bodies of
men, because they believed in a humble Saviour, and he believed in a
lofty. I have bestrode that mitred personage before now; he is the
hack to all the Presbyterians in the pit, but he cannot be spared on a
journey so distant as this.”
“So thou wilt not tell me the name of thy steed?” said Ezra; “well,
even as thou wilt.”
“Nay,” said the spirit, “I shall not deny so good a man so small a
matter. Knowest thou not George Johnstone, the captain of my
troop,—as bold a hand as ever bore a sword and used it among
fanatics? We lived together in life, and in death we are not divided.”
“In persecution and in punishment, thou mightest have said, thou
scoffing spirit,” said the pastor. “But tell me, do men lord it in
perdition as they did on earth; is there no retributive justice among
the condemned spirits?”
“I have condescended on that already,” said the spirit, “and I will
tell thee further: there is thy old acquaintance and mine, George
Gordon; punished and condemned though he be, he is the scourge,
and the whip, and the rod of fire to all those brave and valiant men
who served those equitable and charitable princes, Charles Stewart,
and James, his brother.”
“I suspect why those honourable cavaliers are tasting the cup of
punishment,” said the pastor; “but what crime has sedate and holy
George done that his lot is cast with the wicked?”
“Canst thou not guess it, holy Ezra?” answered the spirit. “His
crime was so contemptible and mean that I scorn to name it. Hast
thou any further questions?”
“You spoke of Charles Stuart, and James, his brother,” said the
pastor; “when sawest thou the princes for whom thou didst deluge
thy country with blood, and didst peril thine own soul?”
“Ah! thou cunning querist,” said the spirit, with a laugh; “canst
thou not ask a plain question? Thou askest questions plain and
pointed enough of the backsliding damsels of thy congregation—why
shouldst thou put thy sanctified tricks on me, a plain and
straightforward spirit, as ever uttered response to the godly?
Nevertheless, I will tell thee; I saw them not an hour ago—Charles
saddled me my steed; wot ye who held my stirrup?—even James, his
brother. I asked them if they had any message to the devout people
of their ancient kingdom of Scotland. The former laughed, and bade
me bring him the kirk repentance-stool for a throne. The latter
looked grave, and muttered over his fingers like a priest counting his
beads; and hell echoed far and wide with laughter at the two
princes.”
“Ay, ay!” said the pastor; “so I find you have mirth among you:
have you dance and song also?”
“Ay, truly,” answered the spirit; “we have hymns and hallelujahs
from the lips of that holy and patriotic band who banished their
native princes, and sold their country to an alien; and the alien
himself rules and reigns among them; and when they are weary with
the work of praise, certain inferior and officious spirits moisten their
lips with cupfuls of a curious and cooling liquid, and then hymn and
thanksgiving recommence again.”
“Ah, thou dissembler,” said the minister; “and yet I see little cause
why they should be redeemed, when so many lofty minds must
wallow with the sinful for a season. But, tell me; it is long since I
heard of Claud Hamilton,—have you seen him among you? He was
the friend and follower of the alien—a mocker of the mighty minds of
his native land—a scoffer of that gifted and immortal spirit which
pours the glory of Scotland to the uttermost ends of the earth—tell
me of him, I pray.”
Loud laughed the spirit, and replied in scorn—
“We take no note of things so mean and unworthy as he; he may be
in some hole in perdition, for aught I know or care. But, stay; I will
answer thee truly. He has not passed to our kingdom yet; he is
condemned to the punishment of a long and useless life on earth;
and even now you will find him gnawing his flesh in agony to hear
the name he has sought to cast down renowned over all the earth.”
The spirit now seemed impatient to be gone; they had emerged
from the glen; and vale and lea, brightened by the moon, and sown
thick with evening dew, sparkled far and wide.
 “If thou wouldst question me farther,” said the frank and
communicative spirit of Bonshaw, “and learn more of the dead, meet
me in the old burial-ground an hour before moon-rise on Sunday
night: tarry at home if thou wilt; but I have more to tell thee than
thou knowest to ask about; and hair of thy head shall not be
harmed.”
Even as he spoke the shape of horse and rider underwent a sudden
transformation—the spirit sank into the shape of a steed, the steed
rose into the form of the rider, and wrapping his visionary mantle
about him, and speaking to his unearthly horse, away he started,
casting as he flew a sudden and fiery glance on the astonished pastor,
who muttered, as he concluded a brief prayer,—
“There goes Captain George Johnstone, riding on his fierce old
master!”
 Chapter III.

The old burial-ground, the spirit’s trysting-place, was a fair but a

lonely spot. All around lay scenes renowned in tradition for blood,
and broil, and secret violence. The parish was formerly a land of
warrior’s towers, and of houses for penance, and vigil, and
mortification. But the Reformation came, and sacked and crushed
down the houses of devotion; while the peace between the two
kingdoms curbed the courage, and extinguished for ever the military
and predatory glory of those old Galwegian chieftains. It was in a
burial-ground pertaining to one of those ancient churches, and
where the peasants still loved to have their dust laid, that Ezra
trusted to meet again the shadowy representative of the fierce old
Laird of Bonshaw.
The moon, he computed, had a full hour to travel before her beams
would be shed on the place of conference, and to that eerie and
deserted spot Ezra was observed to walk like one consecrating an
evening hour to solitary musing on the rivulet side. No house stood
within half a mile; and when he reached the little knoll on which the
chapel formerly stood, he sat down on the summit to ponder over the
way to manage this singular conference. A firm spirit, and a pure
heart, he hoped, would confound and keep at bay the enemy of man’s
salvation; and he summed up, in a short historical way, the names of
those who had met and triumphed over the machinations of fiends.
Thus strengthened and reassured, he rose and looked around, but he
saw no approaching shape. The road along which he expected the
steed and rider to come was empty; and he walked towards the
broken gate, to cast himself in the way, and show with what
confidence he abode his coming.
Over the wall of the churchyard, repaired with broken and carved
stones from the tombs and altar of the chapel, he now looked, and it
was with surprise that he saw a new made widow kneeling over her
husband’s grave, and about to pour out her spirit in lamentation and
sorrow. He knew her form and face, and the deepest sorrow came
upon him. She was the daughter of an old and a faithful elder: she