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 Fundamentals of
Corporate Finance
Eleventh EDITION
THE MCGRAW-HILL EDUCATION SERIES IN FINANCE, INSURANCE, AND REAL ESTATE

FINANCIAL MANAGEMENT Ross, Westerfield, and Jordan Saunders and Cornett

Essentials of Corporate Finance Financial Markets and Institutions
Block, Hirt, and Danielsen Eleventh Edition Eighth Edition
Foundations of Financial Management
Eighteenth Edition Ross, Westerfield, and Jordan
INTERNATIONAL FINANCE
Fundamentals of Corporate Finance
Brealey, Myers, Allen, and Edmans
Principles of Corporate Finance
Thirteenth Edition Eun and Resnick
Fourteenth Edition International Financial Management
Shefrin Eighth Edition
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Principles of Corporate Finance, Concise Decisions that Create Value
Second Edition REAL ESTATE
Second Edition
Brueggeman and Fisher
Brealey, Myers, and Marcus Real Estate Finance and Investments
Fundamentals of Corporate Finance INVESTMENTS
Seventeenth Edition
Eleventh Edition
Bodie, Kane, and Marcus
Ling and Archer
Brooks Essentials of Investments
Real Estate Principles: A Value Approach
FinGame Online 5.0 Twelfth Edition
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Case Studies in Finance: Managing for Investments FINANCIAL PLANNING AND INSURANCE
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 Fundamentals of
Corporate Finance
Eleventh EDITION

Richard A. Brealey
London Business School

Stewart C. Myers
Sloan School of Management,
Massachusetts Institute of Technology

Alan J. Marcus
Carroll School of Management,
Boston College
 Final PDF to printer

FUNDAMENTALS OF CORPORATE FINANCE

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Dedication To Our Families
 About The Authors

Richard A. Brealey
Emeritus Professor of Finance at the London Business School
Professor Brealey is the former president of the European Finance Association and
a former director of the American Finance Association. He is a fellow of the British
Academy and has served as Special Adviser to the Governor of the Bank of England
and as director of a number of financial institutions. Professor Brealey is also the
author (with Stewart Myers, Franklin Allen, and Alex Edmans) of this book’s sister
text, Principles of Corporate Finance (McGraw Hill).

Courtesy of Richard A. Brealey

Stewart C. Myers
Robert C. Merton (1970) Professor of Financial Economics at MIT’s Sloan School of
Management
Dr. Myers is past president of the American Finance Association and a research
associate of the National Bureau of Economic Research. His research has focused on
financing decisions, valuation methods, the cost of capital, and financial aspects of
government regulation of business. Dr. Myers is a director of The Brattle Group, Inc.
and is active as a financial consultant. He is also the author (with Richard Brealey,
Franklin Allen, and Alex Edmans) of this book’s sister text, Principles of Corporate
Finance (McGraw Hill).

Courtesy of Stewart C. Myers

Alan J. Marcus
Mario Gabelli Professor of Finance in the Carroll School of Management at Boston
College
Professor Marcus’s main research interests are in derivatives and securities ­markets.
He is co-author (with Zvi Bodie and Alex Kane) of the texts Investments and
Essentials of Investments (McGraw Hill). Professor Marcus has served as a research
fellow at the National Bureau of Economic Research. Professor Marcus also spent
two years at Freddie Mac, where he helped to develop mortgage pricing and credit
risk models. He currently serves on the Research Foundation Advisory Board of the
CFA Institute.

Courtesy of Alan J. Marcus

vi
Preface

This book is an introduction to corporate finance. It focuses on how companies invest

in real assets, how they raise the money to pay for their investments, and how those
assets ultimately affect the value of the firm. It also provides a broad overview of the
financial landscape, discussing, for example, the major players in financial markets,
the role of financial institutions in the economy, and how securities are traded and
valued by investors. The book offers a framework for systematically thinking about
most of the important financial problems that both firms and individuals are likely to
confront.
Financial management is important, interesting, and challenging. It is important
because today’s capital investment decisions may determine the businesses that the
firm is in 10, 20, or more years ahead. Needless to say, a firm’s success or failure
also depends, in large part, on its ability to find the capital that it requires.
Finance is interesting for several reasons. Financial decisions often involve huge
sums of money. Large investment projects or acquisitions may involve billions of dol-
lars. Also, the financial community is international and fast-moving, with colorful
heroes and a sprinkling of unpleasant villains.
Finance is challenging. Financial decisions are rarely cut and dried, and the finan-
cial markets in which companies operate are changing rapidly. Good managers can
cope with routine problems, but only the best managers can respond to change. To
handle new problems, you need more than rules of thumb; you need to understand
why companies and financial markets behave as they do and when common practice
may not be best practice. Once you have a consistent framework for making financial
decisions, complex problems become more manageable.
This book provides that framework. It is not an encyclopedia of finance. It
focuses instead on setting out the basic principles of financial management and
applying them to the main decisions faced by the financial manager. It explains
how managers can make choices between investments that may pay off at different
points of time or have different degrees of risk. It also describes the main features
of financial markets and discusses why companies may prefer a particular source
of finance.
We organize the book around the key concepts of modern finance. These concepts,
properly explained, simplify the subject. They are also practical. The tools of financial
management are easier to grasp and use effectively when presented in a consistent
conceptual framework. This text provides that framework.
Modern financial management is not “rocket science.” It is a set of ideas that can be
made clear by words, graphs, and numerical examples. The ideas provide the “why”
behind the tools that good financial managers use to make investment and financing
decisions.
We wrote this book to make financial management clear, useful, and fun for the
beginning student. We set out to show that modern finance and good financial practice
go together, even for the financial novice.

Fundamentals and Principles of Corporate Finance

This book is derived in part from its sister text Principles of Corporate Finance. The
spirit of the two books is similar. Both apply modern finance to give students a work-
ing ability to make financial decisions. However, there are also substantial differences
between the two books.

vii
viii Preface

First, we provide in Fundamentals much more detailed discussion of the princi-

ples and mechanics of the time value of money. This material underlies almost all of
this text, and we spend a lengthy chapter providing extensive practice with this key
concept.
Second, we use numerical examples in this text to a greater degree than in Principles.
Each chapter presents several detailed numerical examples to help the reader become
familiar and comfortable with the material.
Third, we have streamlined the treatment of most topics. Whereas Principles has
34 chapters, Fundamentals has only 25. The relative brevity of Fundamentals neces-
sitates a broader-brush coverage of some topics, but we feel that this is an advantage
for a beginning audience.
Fourth, we assume little in the way of background knowledge. While most users
will have had an introductory accounting course, we review the concepts of account-
ing that are important to the financial manager in Chapter 3.
Principles is known for its relaxed and informal writing style, and we continue
this tradition in Fundamentals. In addition, we use as little mathematical notation as
possible. Even when we present an equation, we usually write it in words rather than
symbols. This approach has two advantages. It is less intimidating, and it focuses
attention on the underlying concept rather than the formula.

Organizational Design
Fundamentals is organized in eight parts.

Part 1 (Introduction) provides essential background material. In the first chap-

ter, we discuss how businesses are organized, the role of the financial manager,
and the financial markets in which the manager operates. We explain how share-
holders with many disparate goals might all agree that they want managers to
take actions that increase the value of their investment, and we introduce the
concept of the opportunity cost of capital and the trade-off that the firm needs
to make when assessing investment proposals. We also describe some of the
mechanisms that help to align the interests of managers and shareholders. Of
course, the task of increasing shareholder value does not justify corrupt and
unscrupulous behavior. We, therefore, discuss some of the ethical issues that
confront managers.
Chapter 2 surveys and sets out the functions of financial markets and institutions.
This chapter also reviews the crisis of 2007–2009. The events of those years illustrate
clearly why and how financial markets and institutions matter.
A large corporation is a team effort, so the firm produces financial statements to
help the players monitor its progress. Chapter 3 provides a brief overview of these
financial statements and introduces two key distinctions—between market and book
values and between cash flows and profits. The chapter concludes with a summary of
federal taxes.
Chapter 4 provides an overview of financial statement analysis. In contrast to most
introductions to this topic, our discussion is motivated by considerations of valuation
and the insight that financial ratios can provide about how management has added to
the firm’s value.

Part 2 (Value) is concerned with valuation. In Chapter 5, we introduce the concept of

the time value of money, and because most readers will be more familiar with their
own financial affairs than with the big leagues of finance, we motivate our discussion
by looking first at some personal financial decisions. We show how to value long-lived
streams of cash flows and work through the valuation of perpetuities and annuities.
Preface ix

Chapter 5 also contains a short concluding section on inflation and the distinction
between real and nominal returns.
Chapters 6 and 7 introduce the basic features of bonds and stocks and give stu-
dents a chance to apply the ideas of Chapter 5 to the valuation of these securities.
We show how to find the value of a bond given its yield, and we show how prices
of bonds fluctuate as interest rates change. We look at what determines stock prices
and how stock valuation formulas can be used to infer the return that investors
expect. Finally, we see how investment opportunities are reflected in the stock price
and why analysts focus on the price-earnings multiple. Chapter 7 also introduces
the concept of market efficiency. This concept is crucial to interpreting a stock’s
valuation; it also provides a framework for the later treatment of the issues that
arise when firms issue securities or make decisions concerning dividends or capital
structure.
The remaining chapters of Part 2 are concerned with the company’s investment
decision. In Chapter 8, we introduce the concept of net present value and show how
to calculate the NPV of a simple investment project. We then consider more complex
investment proposals, including choices between alternative projects, machine replace-
ment decisions, and decisions of when to invest. We also look at other measures of an
investment’s attractiveness—its internal rate of return, profitability index, and payback
period. We show how the profitability index can be used to choose between invest-
ment projects when capital is scarce. The appendix to Chapter 8 shows how to sidestep
some of the pitfalls of the IRR rule.
The first step in any NPV calculation is to decide what to discount. Therefore, in
Chapter 9, we work through a realistic example of a capital budgeting analysis, show-
ing how the manager needs to recognize the investment in working capital and how
taxes and depreciation affect cash flows.
We start Chapter 10 by looking at how companies organize the investment
process and ensure everyone works toward a common goal. We discuss how positive-
NPV projects reflect a competitive advantage, and we go on to look at various tech-
niques such as sensitivity analysis, scenario analysis, and break-even analysis that
help managers identify the key assumptions in their estimates, We explain the dis-
tinction between accounting break-even and NPV break-even. We conclude the
chapter by describing how managers try to build future flexibility into projects so
that they can capitalize on good luck and mitigate the consequences of bad luck.

Part 3 (Risk) is concerned with the cost of capital. Chapter 11 starts with a historical
survey of returns on bonds and stocks and goes on to distinguish between the
diversifiable risk and market risk of individual stocks. Chapter 12 shows how to measure
market risk and discusses the relationship between risk and expected return. Chapter 13
introduces the weighted-average cost of capital and provides a practical illustration of
how to estimate it.

Part 4 (Financing) begins our discussion of the financing decision. Chapter 14 pro-
vides an overview of the securities that firms issue and their relative importance as
sources of finance. In Chapter 15, we look at how firms issue securities, and we follow
a firm from its first need for venture capital, through its initial public offering, to its
continuing need to raise debt or equity.

Part 5 (Debt and Payout Policy) focuses on the two classic long-term financ-
ing decisions. In Chapter 16, we ask how much the firm should borrow, and we
summarize bankruptcy procedures that occur when firms can’t pay their debts. In
Chapter 17, we study how firms should set dividend and payout policy. In each
x Preface

case, we start with Modigliani and Miller’s (MM’s) observation that in well-
functioning markets, the decision should not matter, but we use this initial obser-
vation to help the reader understand why financial managers in practice do pay
attention to these decisions.

Part 6 (Financial Analysis and Planning) starts with long-term financial plan-
ning in Chapter 18, where we look at how the financial manager considers the com-
bined effects of investment and financing decisions on the firm as a whole. We also
show how measures of internal and sustainable growth help managers check that
the firm’s planned growth is consistent with its financing plans. Chapter 19 is an
introduction to short-term financial planning. It shows how managers ensure that
the firm will have enough cash to pay its bills over the coming year. Chapter 20
addresses working capital management. It describes the basic steps of credit man-
agement, the principles of inventory management, and how firms handle payments
efficiently and put cash to work as quickly as possible. It also describes how firms
invest temporary surpluses of cash and how they can borrow to offset any temporary
deficiency. Chapter 20 is conceptually straightforward, but it contains a large dollop
of institutional material.

Part 7 (Special Topics) covers several important but somewhat more advanced
t­ opics—mergers (Chapter 21), international financial management (Chapter 22),
options (Chapter 23), and risk management (Chapter 24). Some of these topics
are touched on in earlier chapters. For example, we introduce the idea of options
in Chapter 10, when we show how companies build flexibility into capital proj-
ects. However, Chapter 23 generalizes this material, explains at an elementary
level how options are valued, and provides some examples of why the financial
manager needs to be concerned about options. International finance is also not
confined to Chapter 22. As one might expect from a book that is written by
an international group of authors, examples from different countries and finan-
cial systems are scattered throughout the book. However, Chapter 22 tackles
the specific problems that arise when a corporation is confronted by different
currencies.

Part 8 (Conclusion) contains a concluding chapter (Chapter 25), in which we review

the most important ideas covered in the text. We also introduce some interesting ques-
tions that either were unanswered in the text or are still puzzles to the finance profes-
sion. Thus, the last chapter is an introduction to future finance courses as well as a
conclusion to this one.

Routes through the Book

There are about as many effective ways to organize a course in corporate finance as
there are teachers. For this reason, we have ensured that the text is modular so that top-
ics can be introduced in different sequences.
We like to discuss the principles of valuation before plunging into financial plan-
ning. Nevertheless, we recognize that many instructors will prefer to move directly
from Chapter 4 (Measuring Corporate Performance) to Chapter 18 (Long-Term
Financial Planning) in order to provide a gentler transition from the typical prerequisite
accounting course. We have made sure that Part 6 (Financial Analysis and Planning)
can easily follow Part 1.
Similarly, we like to discuss working capital only after the student is familiar with
the basic principles of valuation and financing, but we recognize that here also
 Preface xi

many instructors prefer to reverse our order. There should be no difficulty in taking
Chapter 20 out of order.
When we discuss project valuation in Part 2, we stress that the opportunity cost of
capital depends on project risk. But we do not discuss how to measure risk or how
return and risk are linked until Part 3. This ordering can easily be modified. For exam-
ple, the chapters on risk and return can be introduced before, after, or midway through
the material on project valuation.

Changes in the Eleventh Edition

Users of previous editions of this book will not find dramatic changes in either the
material or the ordering of topics. But, throughout, we have sought to make the
book more up to date and easier to read. Here are some of the ways that we have
done this.

Improving the Flow A major part of our effort in revising this text was spent on
improving the flow. Often this has meant a word change here or a redrawn diagram
there, but sometimes we have made more substantial changes. For example, the dis-
cussions of forward and spot exchange rates in Chapter 22 are now integrated, which
makes the introduction to the material easier to understand. The material is substan-
tially unchanged, but we think that the flow is much improved.

Updating For many firms, a major focus of the past few years has been on the
impact of Covid. Not surprisingly, references to Covid crop up regularly in this new
edition in discussions of risk management, estimating beta, setting dividend policy,
and so on.
The dozens of real-firm examples in the text have been updated to reflect cur-
rent events in the last three years. These should offer greater name recognition and
salience to the typical reader.
Of course, in each new edition we also try to ensure that any statistics are as up to
date as possible. For example, since the previous edition, we have available an extra
two years of data on security returns. These show up in the figures in Chapter 11 of
the long-run returns on stocks, bonds, and bills. Accounting ratios, data on security
ownership, dividend payments, and stock repurchases are just a few of the other cases
where data have been brought up to date.

New Illustrative Boxes The text contains a number of boxes with illustrative real-
world examples. Many of these are new. Look, for example, at the box in Chapter 1
that raises the question whether managers should maximize the value of stakeholders
as a whole rather than that of the shareholders. Or look at the box in Chapter 15 that
shows how SPACS emerged in 2021 as an important alternative to a traditional IPO for
firms wishing to go public.

Chapter Summaries All chapter summaries have been reorganized into series of
easy-to-digest bullet points.

More Worked Examples We have added more worked examples in the text, many of
them taken from real companies.

Beyond the Page The Beyond the Page digital extensions and applications provide
additional examples, anecdotes, spreadsheet programs, and more thoroughgoing
xii Preface

explanations of some topics. In this edition, we have updated them and added a num-
ber of additional applications and made them easier to access. For example, the appli-
cations are seamlessly available with a click on the e-version of the book, but they are
also readily accessible in the traditional hard copy of the text using the shortcut URLs
provided in the margins of relevant pages.

Specific Chapter Changes in the Eleventh Edition

Here are a few of the additions to chapter material:
Chapter 1 contains updated and timely examples of real capital expenditure decisions
by major corporations as well as an expanded discussion of corporate objectives.
Chapter 2 includes a discussion of prediction markets in the most recent presidential
election.
Chapter 3 includes updated discussions that clarify the treatment of repurchases
in the firm’s equity accounts.
Chapter 6 reorganizes and streamlines the introduction to bond markets and pricing.
Chapter 7 provides new evidence on efficient markets as well as anomalies such
as the GameStop bubble.
Chapter 10 contains a new introduction to the capital investment process and the
problems that arise when project valuations are consciously or unconsciously
biased. We have also completely rewritten the section on scenario analysis.
Chapter 12 now includes a discussion of how betas of many firms responded
to the Covid pandemic and why historical estimates must sometimes be
handled with care.
Chapter 15 now includes a discussion of SPACs. We also discuss why the market
reaction to new stock issues is different in some countries than others.
Chapter 17 streamlines the treatment of dividends and stock dividends.
Chapter 18 uses the example of Dynamic Mattress to show how long-term
planning models can be used to derive the cash flow information for valuing
a business.
Chapter 20 reconsiders inventory policy in light of the supply chain disturbances
resulting from the Covid pandemic.
Chapter 21 provides a reworked overview of both sensible and less compelling
motives for mergers. We have also expanded the discussion of the effect of
mergers on society.
Chapter 22 contains a reworked and reorganized introduction to spot and forward
exchange rates.
Chapter 24 provides an improved treatment of the different ways that firms may
control their risks. We have also added a short section on valuing futures.

Assurance of Learning
Assurance of learning is an important element of many accreditation standards.
Fundamentals of Corporate Finance, Eleventh Edition, is designed specifically to
support your assurance-of-learning initiatives. Each chapter in the book begins with a
list of numbered learning objectives, which are referred to in the end-of-chapter prob-
lems and exercises. Every test bank question is also linked to one of these objectives,
in addition to level of difficulty, topic area, Bloom’s Taxonomy level, and AACSB skill
area. Connect, McGraw-Hill’s online homework solution, and EZ Test, McGraw-Hill’s
easy-to-use test bank software, can search the test bank by these and other categories,
providing an engine for targeted assurance-of-learning analysis and assessment.
Preface xiii

AACSB Statement
McGraw-Hill Education is a proud corporate member of AACSB International.
Understanding the importance and value of AACSB accreditation, Fundamentals of
Corporate Finance, Eleventh Edition, has sought to recognize the curricula guidelines
detailed in the AACSB standards for business accreditation by connecting selected
questions in the test bank to the general knowledge and skill guidelines found in the
AACSB standards.
The statements contained in Fundamentals of Corporate Finance, Eleventh Edition,
are provided only as a guide for the users of this text. The AACSB leaves content cov-
erage and assessment within the purview of individual schools, the mission of the
school, and the faculty. While Fundamentals of Corporate Finance, Eleventh Edition,
and the teaching package make no claim of any specific AACSB qualification or eval-
uation, we have, within the test bank, labeled selected questions according to the six
general knowledge and skills areas.
Unique Features
What makes Fundamentals of Corporate Finance
such a powerful learning tool?

Integrated Examples
Numbered and titled examples are
integrated in each chapter. Students
can learn how to solve specific
problems step-by-step as well as gain
insight into general principles by
seeing how to approach and analyze
different problems.

Confirming Pages

Spreadsheet Solutions Boxes

These boxes provide the student with Spreadsheet Solutions Bond Valuation
detailed examples of how to use Excel Excel and most other spreadsheet programs provide built- Alternatively, we could simply enter the following function

spreadsheets when applying financial
concepts. The boxes include questions
that apply to the spreadsheet, and their
solutions are given at the end of the
applicable chapter. These spreadsheets
are available for download in Connect.
in functions to compute bond values and yields. They typi-
cally ask you to input both the date you buy the bond
in Excel:
=PRICE(DATE(2020,11,15), DATE(2024,11,15), .075, .03, 100, 1)
(called the settlement date) and the maturity date of the
bond. The DATE function in Excel, which we use for both the set-
The Excel function for bond value is:
tlement and maturity dates, uses the format
=PRICE(settlement date, maturity date, annual coupon DATE(year,month,day). We assume the bond makes its cou-
pon payments on the 15th of each month, which is most com-
rate, yield to maturity, redemption value as percent of
face value, number of coupon payments per year) mon, and that it is also purchased and redeemed on the 15th.
Notice that the coupon rate and yield to maturity are
(If you can’t remember the formula, just remember that you
can go to the Formulas tab in Excel, and from the Financial
expressed as decimals, not percentages. In most cases,
redemption value will be 100 (i.e., 100% of face value), and
tab pull down the PRICE function, which will prompt you for
the necessary inputs.) For our 7.5% coupon bond, we would
the resulting price will be expressed as a percent of face
value. Occasionally, however, you may encounter bonds that
enter the values shown in the spreadsheet below. pay off at a premium or discount to face value. One example

A B C D E F
1 7.5% annual 7.5% semiannual 6% annual
2 coupon bond, coupon bond, coupon bond,
3 maturing Nov 2024 Formula in column B maturing Nov 2024 30-year maturity
4
5 Settlement date 15-Nov-2020 =DATE(2020,11,15) 15-Nov-2020 15-Jan-2000
6 Maturity date 15-Nov-2024 =DATE(2024,11,15) 15-Nov 2024 15-Jan-2030
7 Annual coupon rate 0.075 0.075 0.06
8 Yield to maturity 0.03 0.03 0.04
9 Redemption value 100 100 100
(% of face value)

Excel Exhibits 10 Coupon payments

per year
1 2 1

Selected exhibits are set as Excel 11

12
spreadsheets. The accompanying 13 Bond price (% of par) 116.727 =PRICE(B5,B6,B7,B8,B9,B10) 116.843 134.584

files are available for instructors

and students in Connect. The solid curve in Figure 6.6 plots the price of a 30-year maturity, 6% coupon
bond over time assuming that its yield to maturity is currently 4% and does not
change. The price declines gradually until the maturity date, when it finally reaches

FIGURE 6.6 How bond prices

change as they approach 1,400
maturity, assuming an unchanged
1,300 Price path for 6% coupon bond
yield to maturity of 4%. Prices of
selling at a premium to face value
both premium and discount 1,200
bonds approach face value as
their maturity date approaches. 1,100
Bond price ($)

1,000

900

800 Price path for the 2%

coupon discount bond
Today
700 Maturity date
600
30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0
Years to maturity

176
Finance in Practice Boxes
These are excerpts that appear in most
chapters, often from the financial
press, providing real-life illustrations
of the chapter’s topics, such as ethical
choices in finance, disputes about
stock valuation, financial planning,
and credit analysis.

Financial Calculator Boxes

and Exercises
In a continued effort to help students
grasp the critical concept of the time
value of money, many pedagogical
tools have been added throughout
the first section of the text. Financial
Calculator boxes provide examples
for solving a variety of problems,
with directions for the most popular
financial calculators.

Self-Test Questions
Provided in each chapter, these
helpful questions enable students to
check their understanding as they
read. Answers are worked out at the
end of each chapter.
“Beyond the Page” Interactive
Content and Applications
Additional resources and hands-on
applications are just a click away.
Students can tap or click the icons
in the e-version or use the direct
web links to learn more about key
concepts and try out calculations,
tables, and figures when they go
“Beyond the Page.”

Web Exercises
Select chapters include Web Exercises
that allow students to utilize the
Internet to apply their knowledge
and skills with real-world companies.

Minicases
Integrated minicases allow students
to apply their knowledge to relatively
complex, practical problems and
­typical real-world scenarios.
 Supplements
In addition to the overall refinement and improvement of the text material, considerable effort was put into develop-
ing an exceptional supplement package to provide students and instructors with an abundance of teaching and learn-
ing resources.
Instructor Library
The Connect Instructor Library is your
repository for additional resources to
improve student engagement in and out
of class. You can select and use any asset
that enhances your lecture. The Connect
Instructor Library includes all of the
instructor supplements for this text.
Solutions Manual
Nicholas Racculia, Ph.D., at Saint
Vincent’s College worked with the authors
to prepare this resource containing detailed
and thoughtful solutions to all the end-of-
chapter problems.
Instructor’s Manual
This manual, also updated and enhanced by
Nicholas Racculia includes a descriptive
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and case teaching methods, a chapter over-
view and outline, key terms and concepts,
a description of the PowerPoint slides,
video teaching notes, related web links,
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Test Bank
Nicholas Racculia has also thoroughly
reviewed and revised the test bank, add-
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text. More than 2,000 true/false, multiple-
choice, and discussion questions/problems
are available to the instructor at varying
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All questions are tagged by learning objec-
tive, topic, AACSB category, and Bloom’s
Taxonomy level. Complete answers are
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 Acknowledgments

We take this opportunity to thank all of the individuals who helped us prepare this and previous editions. We want
to express our appreciation to those instructors whose insightful comments and suggestions were invaluable to us
during this revision.

Marlena Akhbari Shelley Canterbury Brian E. Young Phillip Giles

Wright State University George Mason University
Timothy Alzheimer Michael Casey
Montana State University University of Central
Arkansas
Tom Arnold
University of Richmond Fan Chen
University of Mississippi
Chung Back
Troy University Peter Chen
Youngstown State University
Robert Balik
Western Michigan University Nicole Choi
Washington State
Anindam Bandopadhyaya
University–Pullman
University of
Peter Chung
Massachusetts–Boston
University of California,
Chenchu Bathala Riverside
Cleveland State University
Bruce Costa
Richard Bauer University of Montana
Saint Mary’s University
Ernie Dancer
LaDoris Baugh Columbus State Community
Athens State University College
Debarati Bhattacharya Kenneth Daniels
Duquesne University Virginia Commonwealth
University
John R. Becker Blease
Washington State Morris Danielson
Saint Joseph’s University
University–Vancouver
Natalya Delcoure
Theologos Bonitsis
Sam Houston State
New Jersey Institute of
University
Technology
Jared DeLisle
Stephen Borde Washington State
University of Central Florida University–Vancouver
Edward Boyer Steven Dennis
Temple University University of North Dakota
Stephen Buell
Robert Dubil
Lehigh University University of Utah–Salt
Deanne Butchey Lake City
Florida International Timothy E. Trombley
University Illinois State University
Southern Methodist Columbia University
University
Gary Gray
Alan D. Eastman Penn State University–
Indiana University of University Park
Pennsylvania
Jason Gurtovoy
Michael Ehrlich California State University,
New Jersey Institute of Northridge
Technology
Brandy Hadley
Richard Elliot Appalachian State University
University of Utah–Salt
John Halstead
Lake City
Liberty University
Mike Evans
Mahfuzul Haque
Winthrop University
Indiana State University
James Falter
Andrew Hession-Kunz
Franklin University
Boston College
John Fay
Larry Holland
Santa Clara University
University of Arkansas–
Richard Fedler Little Rock
Georgia State University
James J. Hopper
Michael Ferguson Mississippi State
University of Cincinnati University
Dov Fobar Jian “Emily” Huang
Brooklyn College California State
University–Chico
Eric Fricke
California State University– Emily Huang
East Bay California State University,
Chico
Steve Gallaher
Southern New Hampshire Stoyu Ivanov
University San Jose State
University
Sharon Garrison
University of Arizona Raymond Jackson
University of
Ashley Geisewite
Massachusetts–Dartmouth
Southwest Tennessee
Community College Keith Jacob
University of Montana
Homaifar Ghassem
Middle Tennessee State Bharat Jain
University Towson University

xx
Benjamas Jirasakuldech Qianqiu Liu Steve Nenninger Thomas Rhee
Slippery Rock University of University of Hawaii–Manoa Sam Houston State University California State University–
Pennsylvania Long Beach
Sheen Liu Hazel Nguyen
Benjamas Jirasakuldech Washington State Southwestern University Jong Rhim
Slippery Rock University University–Vancouver University of Southern
Liem Nguyen
Wilson Liu Indiana
Mark Johnson Westfield State University
Loyola University Maryland James Madison University Joe Riotto
Srinivas Nippani
Scott W. Lowe New Jersey City University
Steve Johnson Texas A&M
Sam Houston State University James Madison University University–Commerce Scott Roark
Qingzhong Ma Boise State University
Daniel Jubinski Prasad Padmanabhan
Saint Joseph’s University Cornell University–Ithaca Saint Mary’s University Mukunthan Santhanakrishnan
Yulong Ma Idaho State University
Alan Jung Ohaness Paskelian
San Francisco State University California State University– University of George Sarraf
Long Beach Houston–Downtown University of California,
Ayala Kayhan
Brian Maris Riverside
Louisiana State University Jeffrey Phillips
Northern Arizona University Colby-Sawyer College Maria Schutte
Marvin Keene
Carol Mannino Michigan Technological
Coastal Carolina University Richard Ponarul
Milwaukee School of University
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Engineering University–Chico Adam Schwartz
University of Arizona
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Dong Man Kim Gary Porter
Central Michigan University Michael Seiler
California State University– John Carroll University
Jinghan Meng College of William & Mary
San Bernardino Eric Powers
University of North John Settle
Jullavut Kittiakarasakun University of South
Carolina–Chapel Hill Portland State University
University of Texas at San Carolina
Antonio Jose Mercardo Michael G. Sher
Ronald Prange
University of Central Metropolitan State
Ladd Kochman Western Michigan
Missouri University
Kennesaw State University University
Paulo Miranda Henry Silverman
David Kuipers Purdue University–Calumet Robert Puelz
University of Missouri– Southern Methodist Roosevelt University
Hammond
Kansas City University Elena Skouratova
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Hawaii Pacific at Buffalo Embry-Riddle University Richard Smith
University–Honolulu Vedpauri Raghavan University of California,
Helen Moser
Embry-Riddle University– Riverside
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Regis University Minneapolis Daytona Beach Ahmad Sohrabian
Ganas K. Rakes University of California,
Doug Letsch Tammie Mosley
Ohio University Irvine
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East Bay Mahdi Rastad Ron Spicer
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University Saginaw Valley State University Roberto Stein
University Adam Reed Tulane University
Yuming Li
California State Vivian Nazar University of North Clifford Stephens
University–Fullerton Ferris State University Carolina–Chapel Hill Louisiana State University

xxi
Tom Strickland Michael Toyne Qiang Wu Athena Zhang
Middle Tennessee State Northeastern State Rensselaer Polytechnic California State
University University University University–Chico
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at Dallas
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Fullerton Kean University
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San Diego State University St. Louis University Arlington
Joe Walker
Steve Tokar University of Woongsun Yoo Zhong-Guo Zhou
University of Indianapolis Alabama–Birmingham Saginaw Valley State California State
University University–Northridge
Damir Tokic Kenneth Washer
University of Texas A&M Kevin Yost Zi Jia
Houston–Downtown University–Commerce Auburn University University of Arkansas at
Kudret Topyan Little Rock
K. Matthew Wong Emilio R. Zarruk
Manhattan College St. John’s University Florida Atlantic University

In addition, we would like to thank Nicholas Racculia, Ph.D., for his help with revisions and updates to our
instructor materials and online content in Connect. His efforts are much appreciated as they will help both students
and instructors. We also appreciate help from Aleijda de Cazenove Balsan and Malcolm Taylor.
We are grateful to the talented staff at McGraw Hill, especially Allison McCabe-Carroll, Senior Product
Developer; Chuck Synovec, Director, Finance; Kevin Moran, Director, Digital Content; Fran Simon and Bruce Gin,
Content Project Managers; Laurie Entringer, Designer; and Trina Mauer, Senior Marketing Manager.
Finally, as was the case with the last ten editions, we cannot overstate the thanks due to our families.

Richard A. Brealey
Stewart C. Myers
Alan J. Marcus

xxii
Contents in Brief

Part One 1 Goals and Governance of the Corporation 2

Introduction 2 Financial Markets and Institutions 32
3 Accounting and Finance 56
4 Measuring Corporate Performance 86

Part Two 5 The Time Value of Money 118

Value 6 Valuing Bonds 166
7 Valuing Stocks 192
8 Net Present Value and Other Investment Criteria 234
9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 270
10 Project Analysis 300

Part Three 11 Introduction to Risk, Return, and the Opportunity Cost of Capital 330
Risk 12 Risk, Return, and Capital Budgeting 360
13 The Weighted-Average Cost of Capital and Company Valuation 392

Part Four 14 Introduction to Corporate Financing 420

Financing 15 How Corporations Raise Venture Capital and Issue Securities 440

Part Five 16 Debt Policy 466

Debt and Payout 17 Payout Policy 504
Policy

Part Six 18 Long-Term Financial Planning 526

Financial Analysis 19 Short-Term Financial Planning 550
and Planning 20 Working Capital Management 570

Part Seven 21 Mergers, Acquisitions, and Corporate Control 610

Special Topics 22 International Financial Management 638
23 Options 664
24 Risk Management 692

Part Eight 25 What We Do and Do Not Know about Finance 712

Conclusion
Appendix A: Present Value and Future Value Tables A-1
Glossary G-1
Index IND-1

xxiii
 Contents

Part One Introduction

Chapter 1 Chapter 3
Goals and Governance of the Corporation 2 Accounting and Finance 56
1.1 Investment and Financing Decisions 4 3.1 The Balance Sheet 58
The Investment (Capital Budgeting) Decision 6 Book Values and Market Values 61
The Financing Decision 6 3.2 The Income Statement 63
1.2 What Is a Corporation? 8 Income versus Cash Flow 64
Other Forms of Business Organization 9 3.3 The Statement of Cash Flows 67
1.3 Who Is the Financial Manager? 10 Free Cash Flow 69
1.4 Goals of the Corporation 12 3.4 Accounting Practice and Malpractice 70
Shareholders Want Managers to Maximize Market Value 12 3.5 Taxes 73
1.5 Agency Problems, Executive Compensation, Corporate Tax 73
and Corporate Governance 15 Personal Tax 74
Executive Compensation 16
Summary 75
Corporate Governance 17
Questions and Problems 76
1.6 The Ethics of Maximizing Value 18
1.7 Careers in Finance 20 Chapter 4
1.8 Preview of Coming Attractions 22 Measuring Corporate Performance 86
1.9 Snippets of Financial History 23 4.1 How Financial Ratios Relate to Shareholder
Summary 25 Value 88

Questions and Problems 26 4.2 Measuring Market Value and Market Value
Added 89
Chapter 2 4.3 Economic Value Added and Accounting
Rates of Return 91
Financial Markets and Institutions 32
Accounting Rates of Return 93
2.1 The Importance of Financial Markets
Problems with EVA and Accounting Rates of Return 95
and Institutions 34
2.2 The Flow of Savings to Corporations 35 4.4 Measuring Efficiency 96

The Stock Market 37 4.5 Analyzing the Return on Assets:

The Du Pont System 98
Other Financial Markets 38
The Du Pont System 98
Financial Intermediaries 40
Financial Institutions 42 4.6 Measuring Financial Leverage 100
Leverage and the Return on Equity 102
Total Financing of U.S. Corporations 44
2.3 Functions of Financial Markets and Intermediaries 45 4.7 Measuring Liquidity 103

Transporting Cash across Time 45 4.8 Interpreting Financial Ratios 104

Risk Transfer and Diversification 45 4.9 The Role of Financial Ratios 108
Liquidity 46 Summary 109
The Payment Mechanism 47 Questions and Problems 110
Information Provided by Financial Markets 47 Minicase 116
2.4 The Crisis of 2007–2009 49

Summary 51
Questions and Problems 52

xxv
xxvi Contents

Part Two Value

Chapter 5 Chapter 7
The Time Value of Money 118 Valuing Stocks 192
5.1 Future Values and Compound Interest 120 7.1 Stocks and the Stock Market 194
5.2 Present Values 123 Reading Stock Market Listings 195
Finding the Interest Rate 127 7.2 Market Values, Book Values, and
5.3 Multiple Cash Flows 128 Liquidation Values 197
Future Value of Multiple Cash Flows 128 7.3 Valuing Common Stocks 199
Present Value of Multiple Cash Flows 129 Valuation by Comparables 199

5.4 Reducing the Chore of the Calculations: Part 1 131 Price and Intrinsic Value 200

Using Financial Calculators to Solve Simple The Dividend Discount Model 202
Time-Value-of-Money Problems 131 7.4 Simplifying the Dividend Discount Model 205
Using Spreadsheets to Solve Simple Case 1: The Dividend Discount Model with No Growth 205
Time-Value-of-Money Problems 132 Case 2: The Dividend Discount Model with Constant
5.5 Level Cash Flows: Perpetuities and Annuities 135 Growth 205
How to Value Perpetuities 135 Case 3: The Dividend Discount Model
How to Value Annuities 136 with Nonconstant Growth 210

Future Value of an Annuity 140 7.5 Valuing a Business by Discounted Cash Flow 214
Annuities Due 143 Valuing the Concatenator Business 214

5.6 Reducing the Chore of the Calculations: Part 2 144 Repurchases and the Dividend Discount Model 215

Using Financial Calculators to Solve Annuity Problems 144 7.6 There Are No Free Lunches on Wall Street 216
Using Spreadsheets to Solve Annuity Problems 145 Random Walks and Efficient Markets 217

5.7 Effective Annual Interest Rates 145 7.7 Market Anomalies and Behavioral Finance 220
5.8 Inflation and the Time Value of Money 147 Market Anomalies 220

Real versus Nominal Cash Flows 147 Bubbles and Market Efficiency 222

Inflation and Interest Rates 149 Behavioral Finance 223

Valuing Real Cash Payments 151 Summary 224

Real or Nominal? 152 Questions and Problems 225

Summary 152 Minicase 232

Questions and Problems 153

Minicase 164
Chapter 8
Net Present Value and Other Investment
Chapter 6 Criteria 234
Valuing Bonds 166 8.1 Net Present Value 236
A Comment on Risk and Present Value 237
6.1 Bond Pricing 168
Valuing Long-Lived Projects 238
6.2 Interest Rates and Bond Prices 171
Choosing between Alternative Projects 240
Interest Rate Risk and Bond Maturity 172
8.2 The Internal Rate of Return Rule 241
6.3 Yield to Maturity 173
A Closer Look at the Rate of Return Rule 242
6.4 Bond Rates of Return 174
Calculating the Rate of Return for Long-Lived Projects 242
6.5 The Yield Curve 177
A Word of Caution 244
Nominal and Real Rates of Interest 178
Some Pitfalls with the Internal Rate of Return Rule 244
6.6 Corporate Bonds and the Risk of Default 180
8.3 The Profitability Index 249
Protecting against Default Risk 183
Capital Rationing 250
Not All Corporate Bonds Are Plain Vanilla 185
Pitfalls of the Profitability Index 250
Summary 185 8.4 The Payback Rule 251
Questions and Problems 186 Discounted Payback 252
 Contents xxvii

8.5 More Mutually Exclusive Projects 252 Calculating the NPV of Blooper’s Mine 283
Problem 1: The Investment Timing Decision 253 Further Notes and Wrinkles Arising from Blooper’s Project 284
Problem 2: The Choice between Long- and Short-Lived
Summary 289
Equipment 254
Questions and Problems 290
Problem 3: When to Replace an Old Machine 256
Minicase 298
8.6 A Last Look 257
Summary 258
Questions and Problems 259 Chapter 10
Minicase 266 Project Analysis 300
Appendix: More on the IRR Rule 267 10.1 The Capital Investment Process, Some Problems,
Using the IRR to Choose between Mutually Exclusive and Some Solutions 302
Projects 267
10.2 Some “What-If” Questions 304
Using the Modified Internal Rate of Return When
Sensitivity Analysis 305
There Are Multiple IRRs 267
Stress Tests and Scenario Analysis 308
10.3 Break-Even Analysis 309
Chapter 9
Accounting Break-Even Analysis 310
Using Discounted Cash-Flow Analysis to Make NPV Break-Even Analysis 311
Investment Decisions 270
Operating Leverage 314
9.1 Identifying Cash Flows 272
10.4 Real Options and the Value of Flexibility 316
Discount Cash Flows, Not Profits 272
The Option to Expand 316
Discount Incremental Cash Flows 274
A Second Real Option: The Option to Abandon 318
Discount Nominal Cash Flows by the Nominal
Cost of Capital 277 A Third Real Option: The Timing Option 318

Separate Investment and Financing Decisions 278 A Fourth Real Option: Flexible Production Facilities 319

9.2 Corporate Income Taxes 279 Summary 320

9.3 An Example—Blooper Industries 279 Questions and Problems 321
Forecasting Blooper’s Cash Flows 280 Minicase 328

Part Three Risk

Chapter 11 11.5 Thinking about Risk 351

Introduction to Risk, Return, and the Message 1: Some Risks Look Big and Dangerous
but Really Are Diversifiable 351
Opportunity Cost of Capital 330
Message 2: Market Risks Are Macro Risks 352
11.1 Rates of Return: A Review 332
Message 3: Risk Can Be Measured 353
11.2 A Century of Capital Market History 333
Market Indexes 333 Summary 354
Questions and Problems 355
The Historical Record 333
Using Historical Evidence to Estimate Today’s Cost Chapter 12
of Capital 336
Risk, Return, and Capital Budgeting 360
11.3 Measuring Risk 338
12.1 Measuring Market Risk 362
Variance and Standard Deviation 338
Measuring Beta 362
A Note on Calculating Variance 341
Betas for Amazon and McDonald’s 365
Measuring the Variation in Stock Returns 341
Total Risk and Market Risk 365
11.4 Risk and Diversification 343 12.2 What Can You Learn from Beta? 367
Diversification 343 Portfolio Betas 367
Asset versus Portfolio Risk 344 The Portfolio Beta Determines the Risk of a Diversified
Market Risk versus Specific Risk 350 Portfolio 370
xxviii Contents

12.3 Risk and Return 371 The NPV of Geothermal’s Expansion 400
Why the CAPM Makes Sense 373 Checking Our Logic 401
The Security Market Line 374 13.3 Interpreting the Weighted-Average Cost of Capital 402
Using the CAPM to Estimate Expected Returns 375 When You Can and Can’t Use WACC 402
How Well Does the CAPM Work? 376 Some Common Mistakes 402
12.4 The CAPM and the Opportunity Cost of Capital 379 How Changing Capital Structure Affects Expected
The Company Cost of Capital 380 Returns 403

What Determines Project Risk? 381 What Happens When the Corporate Tax Rate Is
Not Zero 403
Don’t Add Fudge Factors to Discount Rates 381
13.4 Practical Problems: Measuring Capital Structure 403
Summary 382 13.5 More Practical Problems: Estimating
Questions and Problems 383 Expected Returns 405
The Expected Return on Bonds 405
Chapter 13 The Expected Return on Common Stock 406
The Weighted-Average Cost of Capital and The Expected Return on Preferred Stock 407
Company Valuation 392 Adding It All Up 408
13.1 Geothermal’s Cost of Capital 394 Real-Company WACCs 408
13.2 The Weighted-Average Cost of Capital 395 13.6 Valuing Entire Businesses 409
Calculating Company Cost of Capital Calculating the Value of the Deconstruction Business 410
as a Weighted Average 396
Use Market Weights, Not Book Weights 398 Summary 411
Taxes and the Weighted-Average Cost of Capital 398 Questions and Problems 412
What If There Are Three (or More) Minicase 417
Sources of Financing? 400

Part Four Financing

Chapter 14 Chapter 15
Introduction to Corporate Financing 420 How Corporations Raise Venture Capital
14.1 Creating Value with Financing Decisions 422 and Issue Securities 440
14.2 Patterns of Corporate Financing 422 15.1 Venture Capital 442
Are Firms Issuing Too Much Debt? 424 Venture Capital Companies 443

14.3 Common Stock 425 15.2 The Initial Public Offering 444
Stock Splits 427 Arranging a Public Issue 445

Ownership of the Corporation 427 Other New-Issue Procedures 449

Voting Procedures 428 The Underwriters 450

The Wall Street Walk 429 15.3 General Cash Offers by Public Companies 451
Classes of Stock 429 General Cash Offers and Shelf Registration 452

14.4 Preferred Stock 429 Costs of the General Cash Offer 452
Market Reaction to Stock Issues 453
14.5 Corporate Debt 431
Debt Comes in Many Forms 431 15.4 The Private Placement 454
Innovation in the Debt Market 434 Summary 454
14.6 Convertible Securities 435 Questions and Problems 455
Minicase 460
Summary 436
Appendix: Hotch Pot’s New-Issue Prospectus 461
Questions and Problems 437
 Contents xxix

Part Five Debt and Payout Policy

Chapter 16 Minicase 499

Debt Policy 466 Appendix: Bankruptcy Procedures 501

16.1 How Borrowing Affects Value in a Tax-Free Chapter 17

Economy 468
Payout Policy 504
MM’s Argument—A Simple Example 469
17.1 How Corporations Pay Out Cash to Shareholders 506
How Borrowing Affects Earnings per Share 470
How Firms Pay Dividends 507
How Borrowing Affects Risk and Return 472
Stock Dividends 507
16.2 Debt and the Cost of Equity 474
Stock Repurchases 508
No Magic in Financial Leverage 476
17.2 The Information Content of Dividends and
16.3 Debt, Taxes, and the Weighted-Average
Repurchases 508
Cost of Capital 478
17.3 Dividends or Repurchases? The Payout Controversy 509
Debt and Taxes at River Cruises 478
Dividends or Repurchases? An Example 510
How Interest Tax Shields Contribute to the Value of
Stockholders’ Equity 480 Repurchases and the Dividend Discount Model 511
Corporate Taxes and the Weighted-Average Cost of Capital 480 Dividends and Share Issues 512
The Implications of Corporate Taxes for Capital Structure 482 17.4 Why Dividends May Increase Value 513
16.4 Costs of Financial Distress 482 17.5 Why Dividends May Reduce Value 514
Bankruptcy Costs 483 Taxation of Dividends and Capital Gains
under Current Tax Law 515
Costs of Bankruptcy Vary with Type of Asset 484
Taxes and Payout—A Summary 516
Financial Distress without Bankruptcy 485
17.6 Payout Policy and the Life Cycle of the Firm 516
16.5 Explaining Financing Choices 487
The Trade-Off Theory 487 Summary 518
A Pecking Order Theory 488 Questions and Problems 519
The Two Faces of Financial Slack 489 Minicase 524
Is There a Theory of Optimal Capital Structure? 490

Summary 491
Questions and Problems 492

Part Six Financial Analysis and Planning

Chapter 18 Chapter 19
Long-Term Financial Planning 526 Short-Term Financial Planning 550
18.1 What Is Financial Planning? 528 19.1 Links between Long-Term and Short-Term Financing 552
Why Build Financial Plans? 528 Tax Strategies 553
18.2 Financial Planning Models 529 Reasons to Hold Cash 553
Components of a Financial Planning Model 529 19.2 Tracing Changes in Cash 554
18.3 A Long-Term Financial Planning Model 19.3 Cash Budgeting 556
for Dynamic Mattress 530 Preparing the Cash Budget 556
Pitfalls in Model Design 535 19.4 Dynamic’s Short-Term Financial Plan 559
Choosing a Plan 536 Dynamic Mattress’s Financing Plan 559
Valuing Dynamic Mattress 537 Evaluating the Plan 560
18.4 External Financing and Growth 538 A Note on Short-Term Financial Planning Models 561

Summary 541 Summary 563

Questions and Problems 542 Questions and Problems 563
Minicase 549 Minicase 568
xxx Contents

Chapter 20 Other Payment Systems 591

Working Capital Management 570 Electronic Funds Transfer 592

International Cash Management 593
20.1 Working Capital 572
Components of Working Capital 572 20.5 Investing Idle Cash: The Money Market 594
Working Capital and the Cash Cycle 572 Money Market Investments 594
Calculating the Yield on Money Market Investments 595
20.2 Accounts Receivable and Credit Policy 575
Yields on Money Market Investments 595
Terms of Sale 576
The International Money Market 596
Credit Agreements 577
Credit Analysis 578 20.6 Managing Current Liabilities: Short-Term Debt 596
The Credit Decision 579 Bank Loans 596

Collection Policy 584 Commercial Paper 598

20.3 Inventory Management 586 Summary 599

20.4 Cash Management 589 Questions and Problems 601
Check Handling and Float 589 Minicase 608

Part Seven Special Topics

Chapter 21 21.10 Divestitures, Spin-Offs, and Carve-Outs 628

Mergers, Acquisitions, and Corporate 21.11 The Benefits and Costs of Mergers 630
Control 610 Who Gains and Loses from Mergers? 631
21.1 Types of Mergers 612 Buyers versus Sellers 631
21.2 Sensible Motives for Mergers 613 Mergers and Society 632
Economies of Scale and Scope 613
Summary 632
Economies of Vertical Integration 614
Questions and Problems 633
Complementary Resources 614
Minicase 636
Changes in Corporate Control 615
Industry Consolidation 615 Chapter 22
Industrial Logic Does Not Guaranty Success 615
International Financial Management 638
21.3 Dubious Reasons for Mergers 617
22.1 Foreign Exchange Markets 640
Improved Diversification 617
Spot Exchange Rates 640
The Bootstrap Game 617
Forward Exchange Rates 642
Management Bias 619
22.2 Some Basic Relationships 643
21.4 The Mechanics of a Merger 619
Exchange Rates and Inflation 644
The Form of Acquisition 619
Real and Nominal Exchange Rates 646
Mergers, Antitrust Law, and Popular Opposition 620
Inflation and Interest Rates 647
21.5 Evaluating Mergers 620
The Forward Exchange Rate and the Expected
Mergers Financed by Cash 620 Spot Rate 648
Mergers Financed by Stock 622 Interest Rates and Exchange Rates 650
A Warning 623
22.3 Hedging Currency Risk 651
Another Warning 623
Transaction Risk 651
21.6 The Market for Corporate Control 624 Economic Risk 652
21.7 Proxy Contests 625 22.4 International Capital Budgeting 652
21.8 Takeovers 625 Net Present Values for Foreign
21.9 Leveraged Buyouts 626 Investments 652
Barbarians at the Gate? 627 The Cost of Capital for Foreign Investment 654
 Contents xxxi

Avoiding Fudge Factors 655 Chapter 24

Political Risk 655 Risk Management 692
Summary 657 24.1 Why Hedge? 694
Questions and Problems 658
24.2 Reducing Risk with Options 695
Minicase 663
24.3 Forward and Futures Contracts 695
Chapter 23 The Mechanics of Futures Trading 698
Options 664 Commodity and Financial Futures 700
23.1 Calls and Puts 666 Forward Contracts 700
Selling Calls and Puts 668 24.4 Valuing Futures and Forward Contracts 701
Payoff Diagrams Are Not Profit Diagrams 669 24.5 Swaps 702
Financial Alchemy with Options 670 Interest Rate Swaps 702
Some More Option Magic 671 Currency Swaps 704
23.2 What Determines Option Values? 672 24.6 Innovation in the Derivatives Market 705
Upper and Lower Limits on Option Values 672 24.7 Is “Derivative” a Four-Letter Word? 705
The Determinants of Option Value 673
Summary 706
Option-Valuation Models 675
Questions and Problems 707
23.3 Spotting the Option 678
Options on Real Assets 678
Options on Financial Assets 680

Summary 682
Questions and Problems 683

Part Eight Conclusion

Chapter 25 Are There Important Exceptions to the

Efficient-Market Theory? 717
What We Do and Do Not Know about
Is Management an Off-Balance-Sheet Liability? 718
Finance 712
How Can We Explain Capital Structure? 718
25.1 What We Do Know: The Six Most Important
Ideas in Finance 714 How Can We Resolve the Payout Controversy? 719

Net Present Value (Chapter 5) 714 How Can We Explain Merger Waves? 719

Risk and Return (Chapters 11 and 12) 714 What Is the Value of Liquidity? 719

Efficient Capital Markets (Chapter 7) 715 Why Are Financial Systems Prone to Crisis? 720

MM’s Irrelevance Propositions (Chapters 16 and 17) 715 What Should Be the Goals of the Corporation? 720

Option Theory (Chapter 23) 715 25.3 A Final Word 721

Agency Theory 716 Questions and Problems 721

25.2 What We Do Not Know: Nine Unsolved Problems Appendix A A-1

in Finance 716
Glossary G-1
What Determines Project Risk and Present Value? 716
Risk and Return—Have We Missed Something? 717 Index IND-1
 CHAPTER

Goals and
1 Governance of
the Corporation

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1-1 Give examples of the investment and financing decisions that
financial managers make.
1-2 Distinguish between real and financial assets.
1-3 Cite some of the advantages and disadvantages of organizing a
business as a corporation.
1-4 Describe the responsibilities of the CFO, treasurer, and controller.
1-5 Explain why maximizing market value is the natural financial
goal of the corporation.
1-6 Understand what is meant by “agency problems,” and cite some
of the ways that corporate governance helps mitigate them.
1-7 Understand why maximizing market value does not justify
behaving unethically.

R E L AT E D W E B S I T E S F O R T H I S C H A P T E R C A N B E
F O U N D I N C O N N E C T.

2

To grow from small beginnings to a major corporation, FedEx needed to make good investment and financing decisions.
Sundry Photography/Getty Images
T
o carry on business, a corporation needs an
almost endless variety of assets. Some assets are
tangible, for example, plant and machinery, office
buildings, and vehicles; others are intangible, for exam-
ple, brand names and patents. Corporations finance
these assets by borrowing, by reinvesting profits back
into the firm, and by selling additional shares to the
firm’s shareholders.
Financial managers, therefore, face two broad ques-
tions. First, what investments should the corporation
make? Second, how should it pay for these investments?
Investment decisions spend money. Financing decisions
raise money for investment.
We start this chapter with examples of recent invest-
ment and financing decisions by major U.S. and foreign
corporations. We review what a corporation is and
describe the roles of its top financial managers. We then
turn to the financial goal of the corporation, which is usu-
ally expressed as maximizing value, or at least adding
PA R T O N E
Introduction
value. Financial managers add value whenever the cor-
poration can invest to earn a higher return than its share-
holders can earn for themselves.
But managers are human beings, not perfect servants
who always and everywhere maximize value. We will con-
sider the conflicts of interest that arise in large corpora-
tions and how corporate governance helps to align the
interests of managers and shareholders.
If we ask managers to maximize value, can the corpo-
ration also be a good citizen? Won’t the managers be
tempted to try unethical or illegal financial tricks? They
sometimes may be tempted, but wise managers realize
that such tricks are not just dishonest; they almost
always destroy value, not increase it. More challeng-
ing for the financial manager are the gray areas where
the line between ethical and unethical financial actions
is hard to draw.
Finally, we look ahead to the rest of this book and look
back to some entertaining snippets of financial history.
3
4 Part One Introduction

1.1 Investment and Financing Decisions

Fred Smith is best known today as the founder of FedEx. But in 1965 he was still a
sophomore at Yale, where he wrote an economics term paper arguing that delivery
systems were not keeping up with increasing needs for speed and dependability.1 He
later joined his stepfather at a struggling equipment and maintenance firm for air car-
riers. He observed firsthand the difficulties of shipping spare parts on short notice. He
saw the need for an integrated air and ground delivery system with a central hub that
could connect a large number of points more efficiently than a point-to-point delivery
system. In 1971, at the age of 27, Smith founded Federal Express.
Like many start-up firms, Federal Express flirted again and again with failure.
Smith and his family had an inheritance of a few million dollars, but this was far from
enough. The young company needed to purchase and retrofit a small fleet of aging
Dassault Falcon jets; build a central-hub facility; and hire and train pilots, delivery,
and office staff. The initial source of capital was short-term bank loans. Because of the
company’s shaky financial position, the bank demanded that the planes be used as col-
lateral and that Smith personally guarantee the loan with his own money.
In April 1973, the company went live with a fleet of 14 jets, servicing 25 U.S. cities
out of its Memphis hub. By then, the company had spent $25 million and was effec-
tively flat broke, without enough funds to pay for its weekly delivery of jet fuel. In
desperation, it managed to acquire a bank loan for $23.7 million. This loan had to be
backed by a guarantee from General Dynamics, which in return acquired an option to
buy the company. (Today, General Dynamics must regret that it never exercised this
option.)
In November of that year, the company finally achieved some financial stability
when it raised $24.5 million from venture capitalists, investment firms that provide
funds and advice to young companies in return for a partial ownership share. Eventu-
ally, venture capitalists invested about $90 million in Federal Express.
In 1977, private firms were allowed for the first time to compete with the Postal
Service in package delivery. Federal Express responded by expanding its operations. It
acquired seven Boeing 727s, each with about seven times the capacity of the Falcon
jets. To pay for these new investments, Federal Express raised about $19 million by
selling shares of stock to the general public in an initial public offering (IPO). The new
stockholders became part-owners of the company in proportion to the number of
shares they purchased.
From this point on, success followed success, and the company invested heavily to
expand its air fleet as well as its supporting infrastructure. It introduced an automated
shipping system and a bar-coded tracking system. In 1994, it launched its fedex.com
website for online package tracking. It opened several new hubs across the United
States as well as in Canada, France, the Philippines, and China. In 2007, FedEx (as the
company was now called) became the world’s largest airline measured by number of
planes. FedEx also invested in other companies, capped by the acquisition of TNT
Express for $4.4 billion in 2016. By 2021, FedEx had 400,000 employees, annual rev-
enue of $75 billion, and a stock market value of $67 billion. Its name had become a
verb—to “FedEx a package” was to ship it overnight.
Even in retrospect, FedEx’s success was hardly a sure thing. Fred Smith’s idea was
inspired, but its implementation was complex and difficult. FedEx had to make good
investment decisions. In the beginning, these decisions were constrained by lack of
financing. For example, used Falcon jets were the only option, given the young com-
pany’s precarious financial position. At first it could service only a short list of major
cities. As the company grew, its investment decisions became more complex. Which
type of planes should it buy? When should it expand coverage to Europe and Asia?

1
Legend has it that Smith received a grade of C on this paper. In fact, he doesn’t remember the grade.
 Chapter 1 Goals and Governance of the Corporation 5

How many operations hubs should it build? What computer and tracking systems were
necessary to keep up with the increasing package volume and geographic coverage?
Which companies should it acquire as it expanded its range of services?
FedEx also needed to make good financing decisions. For example, how should it
raise the money it needed for investment? In the beginning, these choices were limited
to family money and bank loans. As the company grew, its range of choices expanded.
Eventually it was able to attract funding from venture capitalists, but this posed new
questions. How much cash did the firm need to raise from the venture capitalists? How
big a share in the firm would the venture capitalists demand in return? The initial
public offering of stock prompted similar questions. How many shares should the
company try to sell? At what price? As the company grew, it raised more funds by bor-
rowing money from its banks and by selling publicly traded bonds to investors. At
each point, it needed to decide on the proper form and terms of financing as well as the
amounts to be raised.
In short, FedEx needed to be good at finance. It had a head start over potential com-
petitors, but a series of bad financial decisions would have sunk the company. No two
companies’ histories are the same, but, like FedEx, all successful companies must
make good investment and financing decisions. And, as with FedEx, those decisions
range from prosaic and obvious to difficult and strategically crucial.
Let’s widen our discussion. Table 1.1 gives an example of a recent investment and
financing decision for 10 corporations. Five are U.S. corporations and five are foreign.
We have chosen very large public corporations that you are likely to be familiar with.
You may have shopped at Walmart, posted a picture on Facebook, or bought a Lenovo
computer.
Take a look at the decisions now. We think you will agree that they appear sensible—
at least there is nothing obviously wrong with them. But if you are new to finance, it
may be difficult to think about why these companies made these decisions and not
others.

TABLE 1.1 Examples of recent investment and financing decisions by major public corporations.

Company Recent Investment Decisions Recent Financing Decisions

Union Pacific Railroad (U.S.)
Shell (U.K./Holland)
Tesla Motors (U.S.)
Ørsted (Denmark)
Facebook (U.S.)
LVMH2 (France)
GlaxoSmithKlein (U.K.)
Walmart (U.S.)
Lenovo (China)
Procter & Gamble (U.S.)
Constructs a new $550 million railroad yard in Texas.
Starts production at a deep-water development site
in the Gulf of Mexico.
Begins battery cell production at its new
Gigafactory in Nevada.
Completes a 230-MW wind farm in Nebraska.
Acquires Giphy, which markets a search engine
for video or GIF files.
Agrees to purchase Tiffany for $15.8 billion.
Spends about $5 billion on research and
development for new drugs.
Sells its British subsidiary (Asda) for $8.8 billion.
Announces plans to build a new manufacturing
facility in India to produce PCs and smartphones
Spends over $7 billion on advertising.
Issues $1.5 billion of 10-year bonds.
Cuts dividend to preserve cash.
Announces plans to raise $5 billion by
issuing new shares to investors.
Arranges a borrowing facility with
14 international banks.
Leases additional office space for its
mega-campus in Fremont, California.
Announces plans to issue €9.3 billion in
euro-denominated debt to help pay for
acquisition of Tiffany.
Pays $4.9 billion in dividends, reinvesting
the remaining $1.5 billion of its profits back
into the firm.
Buys back 54 million shares from investors.
Issues $500 million of dollar bonds and
$850 million of preferred shares.
Buys back $7.4 billion of stock.

2
LVMH (Moët Hennessy Louis Vuitton) markets perfumes and cosmetics, wines and spirits, leather goods,
watches, and other luxury products. And, yes, we know what you are thinking, but “LVMH” really is short for
“Moët Hennessy Louis Vuitton.”
6 Part One Introduction
capital budgeting or capital
expenditure (CAPEX) decision
Decision to invest in tangible
or intangible assets.
financing decision
Decision on the sources
and amounts of financing.
real assets
Assets used to produce
goods and services.
financial assets
Financial claims to the
income generated by the
firm’s real assets.
The Investment (Capital Budgeting) Decision
Investment decisions, such as those shown in Table 1.1, are also called capital
budgeting or capital expenditure (CAPEX) decisions. Some of the investments in
the table, such as Shell’s oil platforms or Tesla’s new factory, involve tangible assets—
assets that you can touch and kick. Others involve intangible assets, such as research
and development (R&D), advertising, and the design of computer software. For exam-
ple, major pharmaceutical manufacturers invest billions every year on R&D for new
drugs.
Sometimes investments can have very-long-term consequences. For example, many
U.S. nuclear power plants, which were initially licensed by the Nuclear Regulatory
Commission to operate for 40 years, are now being relicensed for 20 more years, and
may be able to operate efficiently for 80 years overall. Other investments may pay off
in only a few months. For example, with the approach of the Christmas holidays,
Walmart spends more than $50 billion to stock up its warehouses and retail stores. As
the goods are sold over the following months, the company recovers its investment in
these inventories.
The world of business can be intensely competitive, and corporations prosper only
if they can keep launching new products or services. In some cases, the costs and risks
of doing so are amazingly large. For example, the cost of developing the Gorgon
natural gas field in Australia has been estimated at over $50 billion. It’s not surprising
that this cost is being shared among several major energy companies. But do not think
of companies as making billion-dollar investments on a daily basis. Most investment
decisions are smaller, such as the purchase of a truck, machine tool, or computer
system. Corporations make thousands of such investments each year. The cumulative
amount of these small expenditures can be just as large as the occasional jumbo invest-
ments, such as those shown in Table 1.1.
Not all investments succeed. In October 2011, Hewlett-Packard (HP) paid $11.1 billion
to acquire the British software company Autonomy. Just 13 months later, HP wrote
down the value of this investment by $8.8 billion. HP claimed that it was misled by
improper accounting at Autonomy. Nevertheless, the Autonomy acquisition was a
disastrous investment for HP. HP’s CEO was fired in short order.
There are no guarantees of success in finance. But you can tilt the odds in your
favor if you learn the tools of investment analysis and apply them intelligently. We
cover these tools in detail later in this book.
The Financing Decision
The financial manager’s second main responsibility is to raise the money that the firm
requires for its investments and operations. This is the financing decision. When a
company needs to raise money, it can invite investors to put up cash in exchange for a
share of future profits, or it can promise to pay back the investors’ cash plus a fixed
rate of interest. In the first case, the investors receive shares of stock and become
shareholders, part-owners of the corporation. The investors in this case are referred to
as equity investors, who contribute equity financing. In the second case, the investors
are lenders, that is, debt investors, who one day must be repaid. The choice between
debt and equity financing is often called the capital structure decision. Here “capital”
refers to the firm’s sources of long-term financing. A firm that is seeking to raise long-
term financing is said to be “raising capital.”
Notice the essential difference between the investment and financing decisions.
When the firm invests, it acquires real assets, which are then used to produce the
firm’s goods and services. The firm finances its investment in real assets by issuing
financial assets to investors. A share of stock is a financial asset, which has value as
a claim on the firm’s real assets and on the income that those assets will produce. A
bank loan is a financial asset also. It gives the bank the right to get its money back
plus interest. If the firm’s operations can’t generate enough income to repay the bank,
Chapter 1 Goals and Governance of the Corporation 7

the bank can force the firm into bankruptcy and stake a claim on its real assets. Finan-
cial assets that can be purchased and traded by investors in public markets are called
securities. The shares of stock issued by the public corporations in Table 1.1 are all
securities. Union Pacific’s 10-year bond in Table 1.1 also is a security. But a bank
loan from JPMorgan to Union Pacific would not be called a security.
The firm can issue an almost endless variety of financial assets. Suppose it decides
to borrow. It can issue debt to investors, or it can borrow from a bank. It can borrow for
1 year or 20 years. If it borrows for 20 years, it can reserve the right to pay off the debt
early. It can borrow in Paris, receiving and promising to repay euros, or it can borrow
dollars in New York. (As Table 1.1 shows, LVMH planned to borrow euros, but it
could have borrowed U.S. dollars or British pounds instead.)
In some ways, financing decisions are less important than investment decisions.
Financial managers say that “value comes mainly from the investment side of the bal-
ance sheet.” Also, the most successful corporations sometimes have the simplest
financing strategies. Take Microsoft as an example. It is one of the world’s most valu-
able corporations. In early 2021, Microsoft shares traded for $230 each. There were
7.56 billion shares outstanding. Therefore Microsoft’s market value—its market
capitalization or market cap—was $230 × 7.56 = $1,739 billion. Where did this market
value come from? It came from Microsoft’s products, from its brand name and world-
wide customer base, from its R&D, and from its ability to make profitable future
investments. It did not come from sophisticated financing. Microsoft’s financing
strategy is very simple: It finances almost all investment by retaining and reinvesting
operating cash flow.
Financing decisions may not add much value compared to good investment deci-
sions, but they can destroy value if they are stupid or ambushed by bad news. For
example, when a consortium of investment companies bought the energy giant TXU
in 2007, the company took on an additional $40 billion in debt. This may not have
been a stupid decision, but it did prove fatal. The consortium did not foresee the expan-
sion of shale gas production and the resulting sharp fall in natural gas and electricity
prices. By April 2014 the company (renamed Energy Future Holdings) was bankrupt.

1.1 Self-Test
Are the following capital budgeting or financing decisions? (Hint: In one case the
answer is “both.”)
a. Intel decides to spend $7 billion to develop a new microprocessor factory.
b. BMW borrows 350 million euros (€350 million) from Deutsche Bank.
c. Chevron constructs a pipeline to bring natural gas onshore from a production
platform in Australia.
d. Avon spends €200 million to launch a new range of cosmetics in European
markets.
e. Pfizer issues new shares to buy a small biotech company.

We have emphasized the financial manager’s responsibility for two decisions:

The investment decision = purchase of real assets
The financing decision = sale of financial assets
But this is an oversimplification because the financial manager is also involved in
many other day-to-day activities that are essential to the smooth operation of a busi-
ness. For example, if the firm sells goods or services on credit, it needs to make sure
8 Part One Introduction
1.2 What Is a Corporation?
corporation
A business organized as a
separate legal entity
owned by stockholders.
limited liability
The owners of a corporation
are not personally liable for
its obligations.
Example 1.1 ⊲
that its customers pay on time. Corporations that operate internationally must con-
stantly transfer cash from one currency to another. And the manager must keep an eye
on the risks that the firm runs and ensure that they don’t land the firm in a pickle.
1.2 Self-Test
Which of the following are financial assets, and which are real assets?
a. A patent.
b. A share of stock issued by Wells Fargo Bank.
c. A blast furnace in a steelmaking factory.
d. A mortgage loan taken out to help pay for a new home.
e. After a successful advertising campaign, potential customers trust FedEx to
deliver packages promptly and reliably.
f. An IOU (“I owe you”) from your brother-in-law.
We have been referring to “corporations.” But before going too far or too fast, we need
to offer some basic definitions.
A corporation is a distinct, permanent legal entity. Suppose you decide to create a
new corporation.3 You would work with a lawyer to prepare articles of incorporation,
which set out the purpose of the business and how it is to be financed, managed, and
governed. These articles must conform to the laws of the state in which the business is
incorporated. For many purposes, the corporation is considered a resident of its state.
For example, it can enter into contracts, borrow or lend money, and sue or be sued. It
pays its own taxes (but it cannot vote!).
A corporation’s owners are called shareholders or stockholders.4 The shareholders
do not directly own the business’s real assets (factories, oil wells, stores, etc.). Instead
they have indirect ownership via financial assets (the shares of the corporation).
A corporation is legally distinct from the shareholders. Therefore, the shareholders
have limited liability and cannot be held personally responsible for the corporation’s
debts. When the U.S. financial corporation Lehman Brothers failed in 2008, no one
demanded that its stockholders put up more money to cover Lehman’s massive debts.
Shareholders can lose their entire investment in a corporation, but no more.
Business Organization
Suppose you buy a building and open a restaurant. You have invested in the building itself,
kitchen equipment, dining-room furnishings, plus various other assets. If you do not incorpo-
rate, you own these assets personally, as the sole proprietor of the business. If you have
borrowed money from a bank to start the business, then you are personally responsible for
this debt. If the business loses money and cannot pay the bank, then the bank can demand
3
In the United States, corporations are identified by the label “Corporation,” “Incorporated,” or “Inc.,” as in
Caterpillar Inc. The United Kingdom identifies public corporations by “plc” (short for “Public Limited Corpo-
ration”). French corporations have the suffix “SA” (“Société Anonyme”). The corresponding labels in Germany
are “GmbH” (“Gesellschaft mit beschränkter Haftung”) and “AG” (“Aktiengesellschaft”).
4
“Shareholder” and “stockholder” mean exactly the same thing and are used interchangeably.
 Chapter 1 Goals and Governance of the Corporation 9

that you raise cash by selling other assets—your car or house, for example—in order to repay
the loan. But if you incorporate the restaurant business, and then the corporation borrows
from the bank, your other assets are shielded from the restaurant’s debts. Of course, incor-
poration also means that the bank will be more cautious in lending to you because it will
have no recourse to your other assets.5
Notice that if you incorporate your business, you exchange direct ownership of its real
assets (the building, kitchen equipment, etc.) for indirect ownership via financial assets (the
shares of the new corporation). ■

When a corporation is first established, its shares may be privately owned by a

small group of investors, perhaps the company’s managers and a few backers. In this
case, the shares are not publicly traded and the company is said to be closely held.
Eventually, when the firm grows and new shares are issued to raise additional capital,
its shares are traded in public markets such as the New York Stock Exchange. Such
corporations are known as public companies. Most well-known corporations in the
United States are public companies with widely dispersed shareholdings. In other
countries, it is more common for large corporations to remain in private hands, and
many public companies may be controlled by just a handful of investors.
A large public corporation may have hundreds of thousands of shareholders, who
together own the business. An individual may have 100 shares, receive 100 votes, and
be entitled to a tiny fraction of the firm’s income and value. On the other hand, a pen-
sion fund or insurance company may own millions of shares, receive millions of votes,
and have a correspondingly large stake in the firm’s performance.
Public shareholders cannot possibly manage or control the corporation directly.
Instead, they elect a board of directors, who in turn appoint the top managers and
monitor their performance. This separation of ownership and control gives corpora-
tions permanence. Even if managers quit or are dismissed, the corporation survives.
Today’s stockholders can sell all their shares to new investors without disrupting the
operations of the business. Corporations can, in principle, live forever, and in prac-
tice they may survive many human lifetimes. One of the oldest corporations is the
Hudson’s Bay Company, which was formed in 1670 to profit from the fur trade
between northern Canada and England. HBC still operates retail chains in Canada,
but after a series of divestitures and business reversals, its shareholders voted in 2020
to turn it into a private company, and it was delisted from the Toronto Stock Exchange.
Its reign as perhaps the oldest publicly traded corporation thus came to an end.
The separation of corporate ownership and control can also have a downside, for it
can open the door for managers and directors to act in their own interests rather than in
the stockholders’ interest. We return to this problem later in the chapter.
BEYOND THE PAGE There are other disadvantages to being a corporation. One is the cost, in both time
and money, of managing the corporation’s legal machinery. These costs are particu-
larly burdensome for small businesses.
S-corporations
There is also an important tax drawback to corporations in the United States.
Because the corporation is a separate legal entity, it is taxed separately. So corpora-
www.mhhe.com/brealey11e tions pay tax on their profits, and shareholders are taxed again when they receive divi-
dends from the company or sell their shares at a profit. By contrast, income generated
by businesses that are not incorporated is taxed just once as personal income.6

Other Forms of Business Organization

Corporations do not have to be prominent, multinational businesses such as those
listed in Table 1.1. You can organize a local plumbing contractor or barber shop as a
5
The bank may ask you to put up personal assets as collateral for the loan to your restaurant corporation. But it
has to ask and get your agreement. It doesn’t have to ask if your business is a sole proprietorship.
6
The U.S. tax system is somewhat unusual in this respect. To avoid taxing the same income twice, many other
countries give shareholders at least some credit for the taxes that the corporation has already paid.
10
1.3 Who Is the Financial Manager?
chief financial officer (CFO)
Supervises all financial
functions and sets overall
financial strategy.
Part One Introduction
corporation if you want to take the trouble. But most corporations are larger businesses
or businesses that aspire to grow. Small “mom-and-pop” businesses are usually orga-
nized as sole proprietorships.
What about the middle ground? What about businesses that grow too large for sole
proprietorships but don’t want to reorganize as corporations? For example, suppose
you wish to pool money and expertise with some friends or business associates. You
can form a partnership and enter into a partnership agreement that sets out how deci-
sions are to be made and how profits are to be split up. Partners, like sole proprietors,
face unlimited liability. If the business runs into difficulties, each partner can be held
responsible for all the business’s debts. However, partnerships have a tax advantage.
Partnerships, unlike corporations, do not have to pay income taxes. The partners pay
personal income taxes on their shares of the profits.
Some businesses are hybrids that combine the tax advantage of a partnership with
the limited liability advantage of a corporation. In a limited partnership, partners are
classified as general or limited. General partners manage the business and have unlim-
ited personal liability for its debts. Limited partners are liable only for the money they
invest and do not participate in management.
Many states allow limited liability partnerships (LLPs) or limited liability compa-
nies (LLCs). These are partnerships in which all partners have limited liability. Another
variation on the theme is the professional corporation (PC), which is commonly used
by doctors, lawyers, and accountants. In this case, the business has limited liability,
but the professionals can still be sued personally, for example, for malpractice.
Most large investment banks such as Morgan Stanley and Goldman Sachs started
life as partnerships. But eventually these companies and their financing requirements
grew too large for them to continue as partnerships, and they reorganized as corpora-
tions. The partnership form of organization does not work well when ownership is
widespread and separation of ownership and management is essential.
What do financial managers do for a living? That simple question can be answered in
several ways. We can start with financial managers’ job titles. Most large corporations
have a chief financial officer (CFO), who oversees the work of all financial staff. As
you can see from Figure 1.1, the CFO is deeply involved in financial policy and finan-
cial planning and is in constant contact with the chief executive officer (CEO) and
other top management. The CFO is the most important financial voice of the corpora-
tion and explains earnings results and forecasts to investors and the media.
FIGURE 1.1 Financial managers in large corporations.
Chief Financial Officer (CFO)
Responsible for:
Financial policy
Corporate planning
Treasurer Controller
Responsible for: Responsible for:
Cash management Preparation of financial statements
Raising of capital Accounting
Banking relationships Taxes

treasurer
Responsible for financing,
cash management, and
relationships with banks
and other financial
institutions.
controller
Responsible for budgeting,
accounting, and taxes.
BEYOND THE PAGE
The financial
managers
www.mhhe.com/brealey11e
FIGURE 1.2 Flow of cash
between investors and the firm’s
operations. Key: (1) Cash raised
by selling financial assets to
investors; (2) cash invested in the
firm’s operations; (3) cash
generated by the firm’s
operations; (4a) cash reinvested;
(4b) cash returned to investors.
Chapter 1 Goals and Governance of the Corporation 11
Below the CFO are usually a treasurer and a controller. The treasurer looks after
the firm’s cash, raises new capital, and maintains relationships with banks and investors
that hold the firm’s securities. The controller prepares the financial statements, manages
the firm’s internal budgets and accounting, and looks after its tax affairs. Thus, the
treasurer’s main function is to obtain and manage the firm’s capital, whereas the con-
troller ensures that the money is used efficiently.
1.3 Self-Test
Fritz and Frieda went to business school together 10 years ago. They have just
been hired by a midsize corporation that wants to bring in new financial manag-
ers. Fritz studied finance, with an emphasis on financial markets and institutions.
Frieda majored in accounting and became a CPA five years ago. Who is more
suited to be treasurer and who controller? Briefly explain.
In large corporations, financial managers are responsible for organizing and super-
vising the capital budgeting process. However, major capital investment projects are
so closely tied to plans for product development, production, and marketing that man-
agers from these other areas are inevitably drawn into planning and analyzing the proj-
ects. If the firm has staff members specializing in corporate planning, they are naturally
involved in capital budgeting too. For this reason, we will use the term financial man-
ager to refer to anyone responsible for an investment or financing decision. Often we
will use the term collectively for all the managers drawn into such decisions.
Now let’s go beyond job titles. What is the essential role of the financial manager?
Figure 1.2 gives one answer. The figure traces how money flows from investors to the
corporation and back again to investors. The flow starts when cash is raised from
investors (arrow 1 in the figure). The cash could come from banks or from securities
sold to investors in financial markets. The cash is then used to pay for the real assets
(investment projects) needed for the corporation’s business (arrow 2). Later, as the
business operates, the assets generate cash inflows (arrow 3). That cash is either rein-
vested (arrow 4a) or returned to the investors who furnished the money in the first
place (arrow 4b). Of course, the choice between arrows 4a and 4b is constrained by the
promises made when cash was raised at arrow 1. For example, if the firm borrows
money from a bank at arrow 1, it must repay this money plus interest at arrow 4b.
You can see examples of arrows 4a and 4b in Table 1.1. Glaxo partly financed its
investments in R&D by reinvesting earnings (arrow 4a). Procter & Gamble decided to
return cash to shareholders by buying back its stock (arrow 4b). It could have chosen
instead to pay the money out as additional cash dividends, also on arrow 4b.
Notice how the financial manager stands between the firm and outside investors. On
the one hand, the financial manager is involved in the firm’s operations, particularly by
(2) (1)
Firm’s
Operations Investors
Financial
(4a)
Manager
Real Assets Financial Assets
(3) (4b)
12 Part One Introduction

helping to make good investment decisions. On the other hand, he or she deals with
financial institutions and other investors and with financial markets such as the New
York Stock Exchange. We say more about these financial institutions and markets in
the next chapter.

1.4 Goals of the Corporation

Shareholders Want Managers to Maximize Market Value
For small corporations, shareholders and management may be one and the same.
But for large corporations, separation of ownership and management is a practical
necessity. For example, Walmart has more than 100,000 distinct shareholders.
There is no way that these shareholders can be actively involved in management; it
would be like trying to run New York City by town meetings. Authority has to be
delegated.
How can shareholders effectively delegate decision making when they all have dif-
ferent tastes, wealth, time horizons, personal opportunities, and tolerance for risk?
Delegation can work only if the shareholders have a common goal. Fortunately there is
a natural financial objective on which almost all shareholders can agree: Maximize the
current market value of shareholders’ investment in the firm.
BEYOND THE PAGE This simple, unqualified goal makes sense when the shareholders have access
to well-functioning financial markets and institutions. Access gives them the flex-
Foundations of ibility to manage their own savings and consumption plans, leaving the corpora-
the NPV rule
tion’s financial managers with only one task, to increase market value. For
example, a corporation’s roster of shareholders will usually include both risk-
www.mhhe.com/brealey11e
averse and risk-tolerant investors. You might expect the risk-averse to say, “Sure,
maximize value, but don’t touch too many high-risk projects.” Instead, they say,
“Risky projects are okay, provided that expected profits are more than enough to
compensate me for the risks. If this firm ends up too risky for my taste, I’ll adjust
my investment portfolio to make it safer.” For example, the risk-averse shareholder
can shift more of his or her portfolio to safe assets, such as U.S. government
bonds. Shareholders can also just say good-bye, selling off shares of the risky
firm and buying shares in a safer one. If the risky investments increase market
value, the departing shareholders are better off than they would be if the risky
investments were turned down.

Example 1.2 ⊲ Value Maximization

Fast-Track Wireless shares trade for $20. It has just announced a “bet the company”
investment in a high-risk, but potentially revolutionary, WhyFi technology. Investors note
the risk of failure but are even more impressed with the technology’s upside. They conclude
that the possibility of very high future profits justifies a higher share price. The price goes
up to $23.
Caspar Milquetoast, a thoughtful but timid shareholder, notes the downside risks and
decides that it’s time for a change. He sells out to more risk-tolerant investors. But he sells at
$23 per share, not $20. Thus, he captures the value added by the WhyFi project without
having to bear the project’s risks. Those risks are transferred to other investors, who are
more risk-tolerant or more optimistic.
In a well-functioning stock market, there is always a pool of investors ready to bear downside
risks if the upside potential is sufficiently attractive. We know that the upside potential was suf-
ficient in this case because Fast-Track stock attracted investors willing to pay $23 per share. ■
Chapter 1 Goals and Governance of the Corporation 13

The same principles apply to the timing of a corporation’s cash flows, as the follow-
ing Self-Test illustrates.

1.4 Self-Test
Rhonda and Reggie Hotspur are working hard to save for their children’s college
education. They don’t need more cash for current consumption but will face big
tuition bills in 2031. Should they therefore avoid investing in stocks that pay
generous current cash dividends? (Hint: Are they required to spend the divi-
dends on current consumption?) Explain briefly.

Sometimes you hear managers speak as if the corporation has other goals. For
example, they may say that their job is to “maximize profits.” That sounds reasonable.
After all, don’t shareholders want their company to be profitable? But taken literally,
profit maximization is not a well-defined corporate objective. Here are two reasons:
1. Maximize profits? Which year’s profits? A corporation may be able to increase
current profits by cutting back on outlays for maintenance or staff training, but that
will not add value unless the outlays were wasteful in the first place. Shareholders
will not welcome higher short-term profits if long-term profits are damaged.
2. A company may be able to increase future profits by cutting this year’s dividend
and investing the freed-up cash in the firm. That is not in the shareholders’ best
interest if the company earns only a very low rate of return on the extra investment.
Maximizing—or at least maintaining—value is necessary for the long-run survival of
the corporation. Suppose, for example, that its managers forget about value and decide
that the only goal is to increase the market share of its products. So the managers cut
prices aggressively to attract new customers, even when this leads to continuing losses.
As losses mount, the corporation finds it more and more difficult to borrow money and
sooner or later cannot pay existing debts. Nor can it raise new equity financing if share-
holders see that new equity investment will follow previous investments down the drain.
This firm’s managers would probably pay the price for this business misjudgment.
For example, outside investors would see an opportunity for easy money. They could
buy the firm from its current shareholders, toss out the managers, and reemphasize
value rather than market share. The investors would profit from the increase in value
under new management.
Managers who pursue goals that destroy value often end in early retirement—another
reason that the natural financial goal of the corporation is to maximize market value.
We don’t want to leave the impression that value maximization justifies ruthless
and unethical behavior. It does not. Moreover, in most circumstances, ethical behavior
can be value maximizing because it serves to cement the firm’s reputation as both a
trustworthy purveyor of goods as well as a decent employer. We will return to this
issue later in the chapter.

The Investment Trade-Off Okay, let’s take the objective as maximizing market
value, or at least adding market value. But why do some investments increase market
value, while others reduce it? The answer is given by Figure 1.3, which sets out the
fundamental trade-off for corporate investment decisions. The corporation has a pro-
posed investment project (the purchase of a real asset). Suppose it has sufficient cash
on hand to finance the project. The financial manager is trying to decide whether to go
ahead. If he or she decides not to invest, the corporation can pay out the cash to share-
holders, say as an extra dividend. (The investment and dividend arrows in Figure 1.3
are arrows 2 and 4b in Figure 1.2.)
Assume that the financial manager is acting in the interests of the corporation’s
owners, its stockholders. What do these stockholders want the financial manager
14 Part One Introduction

FIGURE 1.3 The firm can

either keep and reinvest cash or
return it to investors. (Arrows
Cash
represent possible cash flows or
transfers.) If cash is reinvested,
the opportunity cost is the
expected rate of return that
shareholders could have
obtained by investing in Investment Investment
financial assets. opportunity Firm Shareholders opportunities
(real asset) (financial assets)

Invest Alternative: Shareholders

pay out cash invest for
to shareholders themselves

to do? The answer depends on the rate of return on the investment project and on the
rate of return that stockholders can earn by investing in financial markets. If the return
offered by the investment project is higher than the rate of return that shareholders can
get by investing on their own, then the shareholders would vote for the investment
project. If the investment project offers a lower return than shareholders can achieve
on their own, the shareholders would vote to cancel the project and take the cash
instead.
Perhaps the investment project in Figure 1.3 is a proposal for Tesla to launch a new
electric car. Suppose Tesla has set aside cash to launch the new model in 2025. It could
go ahead with the launch, or it could cancel the investment and instead pay the cash
out to its stockholders.
Suppose that Tesla’s new project is just about as risky as the stock market and that
investment in the stock market offers a 10% expected rate of return. If the new project
offers a superior rate of return, say 20%, then the stockholders would be happy to let
the company keep the cash and invest it in the new model. If the project offers only a
5% return, then the stockholders are better off with the cash and without the new
­project; in that case, the financial manager should turn down the project.
As long as a corporation’s proposed investments offer higher rates of return than its
shareholders can earn for themselves in the stock market (or in other financial markets),
its shareholders will applaud the investments and the market value of the firm will
increase. But if the company earns an inferior return, shareholders are despondent, the
stock price falls, and stockholders clamor to get their money back so that they can
invest on their own.
In our example, the minimum acceptable rate of return on Tesla’s new project is
opportunity cost of capital 10%. This minimum rate of return is called the hurdle rate or opportunity cost of
The minimum acceptable capital. It is called an opportunity cost of capital because it depends on the alternative
rate of return on capital investment opportunities available to shareholders in financial markets. Whenever a
investment set by the corporation invests cash in a new project, its shareholders lose the opportunity to
investment opportunities invest the cash on their own. Corporations increase value by accepting investment
available to shareholders
projects that earn more than the opportunity cost of capital.
in financial markets.
Figure 1.3, which compares rates of return on investment projects with the opportu-
nity cost of capital, illustrates a general principle: A corporation should direct cash to
investments that offer a higher return than shareholders could earn for themselves.7

7
We have mentioned 5% or 20% as possible future rates of return on Tesla’s project. We will see in Chapter 8
that future rates of return are sometimes difficult to calculate and interpret. The general principle always holds,
however. In Chapters 8 and 9 we show you how to apply the principle by calculating the net present value
(NPV) of investment projects.
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we’ve got the right one, anyhow. This bird don’t look to me like a
feller who would do a girl a meanness.”
“Hmp! You always was soft in the head, Burt,” his companion
grunted.
But he left his prisoner in peace after that. Burt had said one true
word. Clint Reed would not want a half-dead hobo dragged to the
Diamond Bar K. He would prefer one that he could punish himself.
Tug plodded through the fine white dust that lay inches deep on the
road. A cloud of it moved with them, for the horses kicked it up at
every step until they ascended from the valley into the hills. The man
who walked did not have the reserve of strength that had been his
before he had gone to the hospital. There had been a time when he
could go all day and ask for more, but he could not do it now. He
stumbled as he dragged his feet along the trail.
They reached the summit of the pass and looked down on the
Diamond Bar K. Its fenced domain was a patchwork of green and
gold with a background of pineclad ridges. The green patches were
fields of alfalfa, the gold squares were grain ripe for the mower.
Downhill the going was easier. But by the time the horsemen and
their prisoner drew up to the ranch house, Tug was pretty well
exhausted.
While Dusty went in to get Reed, the tramp sat on the floor of the
porch and leaned against a pillar, his eyes closed. He had a
ridiculous feeling that if he let go of himself he would faint.
 CHAPTER VI
“NOTHING BUT A GAY-CAT ANYHOW”

With an unusual depression Betty had watched the tramp move

down the dusty road to the railroad track after he had declined her
offer of employment. An energetic young person, she was
accustomed to having her own way. One of her earliest delightful
discoveries had been that she could nearly always get what she
wanted by being eager for it and assuming that, of course, the others
involved would recognize her plan as best, or at least would give up
theirs cheerfully when she urged hers.
But this ragged scamp, out of whose heart youth and hope had been
trampled, was leaving her dashed and rebuffed. She liked to make
conquests of people in bending them to the schemes she made for
the regulation of her small universe, though she would have denied
even to herself that she liked to manage her friends. In the case of
this drear-eyed boy, the hurt was not only to her vanity. He might be
five or six years older than she, but the mothering instinct—the
desire to save him from himself and his fate—fluttered yearningly
toward him.
She did not blame him. There was at least a remnant of self-respect
in his decision. Nobody wants to be done good to. Perhaps she had
seemed smug to him, though she had not meant to be.
He was on her mind all the way back to the ranch, so much so that
she blurted out the whole story to her father as soon as she saw him.
Clint Reed moved to prompt action. He did not see eye to eye with
his daughter. What concerned him was that these bums should
waylay and insult Betty. It was a nice state of affairs when a girl was
not safe alone on the roads. He gathered his men and gave them
orders to find the hoboes and bring them to the ranch.
The girl’s protest was lost on Reed. It hardly reached his mind at all.
Besides, this had become public business. It was not her personal
affair. If hoboes needed to be taught a sense of decency, the men of
the community would attend to that.
Betty went into the house dissatisfied with herself. She had not
meant to make more trouble, but to enlist her father’s sympathy in
the cause of the young fellow who had saved her from the other
tramp. As for the one who had attacked her, she did not care
whether he was punished or not. She had much rather no hue and
cry over the country was made about it. Though she did not say so,
she hoped the vagrants would get away uncaught.
She busied herself with household duties. Under her direction and
with her help, Bridget the cook was putting up half a dozen boxes of
peaches. The two women worked into the middle of the hot
afternoon before they had finished.
“An’ that’s that,” Bridget said with a sigh of relief as she sealed the
last jar. “Fegs, I don’t mind a hotter day this summer. It’s a b’iler.”
She was an old family servant and was in part responsible for the
bringing up of Betty. More than one rancher in the neighborhood had
attempted the adventure of wooing Bridget Maloney, but none of
them had been able to lure her from the Diamond Bar K to become
the mistress of a home of her own.
“You’d better lie down and sleep an hour, dear,” the girl advised.
“An’ phwat would I be doin’ that for wid all these kettles an’ pots to
be cleaned up? Scat! Get ye out o’ my kitchen now, mavourneen, an’
I’ll redd up in a jiff.”
Betty found a magazine and walked out to the shade of a pine grove
where a hammock hung. She settled herself comfortably and began
to read. It was delightfully cool among the pines after the hot kitchen.
She grew drowsy. Her eyes closed.
The sound of far-away voices was in her ears when she wakened.
As her thoughts cleared, so did the voices. She heard Dusty’s,
strident, triumphant.
“It’s up to the old man now.”
The girl turned in the hammock and saw the squat cowpuncher go
jingling into the house. Burt lounged on a horse, his right leg thrown
round the horn of the saddle. Some one else, partly hidden from her
by the ponies, was sitting on the porch.
She got up quickly and walked toward the house. The man on the
porch, she saw presently, had a rope around his waist the other end
of which was fastened to the saddle of Dusty’s mount. An eyeflash
later she recognized him.
“You!” she cried.
The tramp called Tug rose. He did not lift his hat, for he no longer
had one. But his bow and sardonic smile gave an effect of ironic
politeness.
“The bad penny back again,” he said.
“What have they been doing to you?” she asked breathlessly.
He had been a disreputable enough specimen when she had last
seen him. The swollen and discolored face, the gaping shoes, the
ragged coat; all of these he had carried then. But there were
scratches like skin burns down one side of the jaw and on his hands
that had come since. His coat was in shreds. From head to foot dust
covered every available inch.
“Your men have been having a little sport. Why not? The boss had
his first and they had to follow his example. They’re good obedient
boys,” he scoffed bitterly.
“What do you mean? What did they do?” she demanded sharply.
He shrugged his shoulders and she turned imperiously to the man
on horseback. “Burt, you tell me.”
The lank cowboy showed embarrassment. “Why, Dusty he—he
kinda dragged him when the fellow lagged. Jus’ for a ways.”
“On the ground? That what you mean?” The dark eyes flashed
anger.
“Well, you might say so. He sorta stumbled, an’ he’d been right
sassy to Dusty, so—” Burt’s explanation died away. He felt he was
not getting very far with it.
“So you acted like brutes to him—to a man who had just fought for
me when—when—” A sob of chagrin and vexation choked up in her
throat. She stamped her foot in exasperation.
“Don’t get excited about me,” the victim gibed. “I’m nothing but a
gay-cat anyhow. What’s it matter?”
Dusty strutted out of the house, his spurs making music.
The girl turned on him with pantherish swiftness.
“Who told you to torture this man, Dusty? What right have you got to
make yourself law on the Diamond Bar? You’re only a drunken
lunkhead, aren’t you? Or did Father ask you to be judge and jury on
the ranch?”
It was ludicrous to see the complacency vanish from the fatuous
face. The jaw fell and the mouth opened.
“Why, Miss Betty, I figured as how he’d done you a meanness, an’ I
thought—”
She cut his explanation short with stinging ruthlessness. “What for?
You weren’t hired to think, but to obey orders. You’d better get back
into the wheatfield before Father comes. Pronto.”
The cowboy shut his mouth with a view to opening it again in self-
defense, but Betty would have none of his excuses. She shooed him
from the scene indignantly. While she was busy with Dusty, the lank
rider quietly vanished.
The prisoner watched her, the rope still about his waist. His mind
paid tribute to the energy with which she got results.
“Greatly obliged,” he said with sarcasm. “I suppose your father won’t
have me hanged now.”
“Take off that rope,” she said.
“That’s an order, is it?”
“I don’t blame you for hating us all,” she flamed. “I would in your
place. The whole place is bewitched to-day, I believe. We’re all
acting like bullies instead of the quiet, decent people we are. Take
Dusty now. He’s a good little fellow, but he thought you’d attacked
me. He wouldn’t stand that. Men in the ranch country won’t, you
know. They look after us women.”
“That’s a peculiarity of the ranch country, I suppose.”
She ignored the derisive gleam in his eyes. “No ... no! Good men
always do. I wish I could tell you—could show you—my thanks
because you stood up for me. I’ll never forget. It was fine, the way
you fought for me.”
“Nothing to that. I’d been saving a punch or two for him. Don’t forget
that I’m a good-for-nothing bum, on the authority of your own father.
No need of getting sentimental. Don’t make the mistake of putting
me in a class with him and other such truly good men as your friend
Dusty and the lamblike foreman who beat up Cig because he
wouldn’t apologize for being alive.”
Voice and manner both fleered at her, but she was determined to
accept no rebuff.
“Did Dusty hurt you? Can I do anything for you? Tell me. I’d be so
glad to. Let me get you a drink.”
Like a flash, she was off at her own suggestion to the kitchen. His
impulse was to go at once, but he could not escape his past and be
deliberately discourteous to a woman whose only desire was to help
him. He waited, sullenly, for her return. Why could she not let him
alone? All he asked of the Diamond Bar K was for it to let him get
away and forget it as soon as possible.
When the girl came back, it was with a pitcher and a glass. The
outside of the jug was beaded with moisture. From within came the
pleasant tinkle of ice.
Betty filled the tumbler with lemonade.
The vagabond had no desire to accept the hospitality of the ranch,
but he found it impossible to affront her churlishly again.
“Thank you,” he said, and drank.
The drink was refreshing. Two fresh-beaten eggs had been stirred
into it for nutrition.
“Another?” she begged, and poured without waiting for an answer.
The ghost of a smile crept into his eyes. It was the first hint of
wholesome humor she had yet seen in him. He offered her, with a
little bow, a quotation.
“‘I can no other answer make, but thanks,
And thanks, and ever thanks.’”
The dimples broke into her cheeks as her smile flashed out in the
pleasure of having broken the crust of his reserve.
“That’s Shakespeare, isn’t it? I’m dreadfully illiterate, but it sounds
like him.”
“It does a little, doesn’t it?” He raised the glass before drinking.
“Happy days, Miss Reed.”
“That goes double,” she said quickly.
The sardonic mask, that had for a moment been lifted, dropped
again over his face. “Many more like this one,” he fleered.
“You may look back on it and find it a good day yet,” she said
bravely.
He handed back the empty tumbler. “Afraid I’m not an optimist. Now,
if you don’t mind, I’ll be going. The ranch might change its mind
about that hanging bee.”
“But I do mind,” she protested. “I don’t want you to go yet. Please
stay and meet my father. He’s not really hard and cruel as you think.”
Again she saw on his lips the dry, bitter smile.
“Think I’ll take your word for it. I’ve met him once.”
“No, you haven’t met him—not to know him,” she cried softly, giving
rein to swift impulse. “You’ve not met my Daddy—the best man in
Paradise Valley. You can ask any one about him. He’s the squarest
that ever was. The man you met was exasperated and—and not
himself. Dad’s not like that—really.”
“Indeed!” His voice was a compound of incredulity and indifference.
It put her out of court.
But her good impulses were not easily daunted. She had already
learned that this young fellow wore armor of chain-mail to protect his
sensitive pride. In her horoscope it had been written that she must
give herself, and still give and give. The color beat through her dusky
cheeks beneath the ardent eyes. She stabbed straight at his
jaundiced soul.
“If it were my father only that you don’t like—but it isn’t—you don’t
find joy in anything. Your mind’s poisoned. I was reading the other
day how Mr. Roosevelt used to quote from Borrow’s ‘Lavengro’: ‘Life
is sweet, brother—there’s day and night, brother; both sweet things;
sun, moon, and stars, all sweet things—and likewise there’s a wind
on the heath.’ It’s because he felt this in everything he did that they
called him ‘Greatheart.’”
It came to him that the name might not inaptly be applied to her. He
thought of Browning’s “My Last Duchess”:
“... She had
A heart—how shall I say?—too soon made glad,
Too easily impressed: she liked whate’er
She looked on, and her looks went everywhere.”
He hardened his heart to her generous appeal to him. “It’s a very
comfortable point of view to have,” he said with no spring of life in his
voice.
“And a true one,” she added swiftly.
“If you say so, of course.” His skeptical smile made no concessions.
He turned to leave, but stopped to look at a cloud of white dust
moving down the road toward them.
 CHAPTER VII
TUG SAYS, “NO, THANK YOU”

The advancing dust cloud rose from a little group of horses and men.
Some of the latter were riding. Others were afoot.
“Lon’s caught them,” said Betty. “I’m sorry.”
“Not so sorry as they’ll be,” returned the ragged youth grimly.
The foreman swung heavily from his horse. Though he was all
muscle and bone, he did not carry his two hundred pounds
gracefully.
“We got the birds all right, Miss Betty, even if they were hittin’ the trail
right lively,” he called to the girl, an ominous grin on his leathery
face. “I guess they’d figured out this wasn’t no healthy climate for
them.” He added, with a swift reversion to business, “Where’s yore
paw?”
“Not back yet. What’ll he do with them, Lon?” the girl asked, her
voice low and troubled.
Distressed in soul, she was looking for comfort. The big foreman
gave her none.
“He’ll do a plenty. You don’t need to worry about that. We aim to
keep this country safe for our womenfolks.”
“Oh, I wish he wouldn’t. I wish he’d let them go,” she said, almost in
a wail.
“He won’t. Clint ain’t that soft.” Forbes stared at the disreputable
vagrant standing beside Betty. “What’s he doing here?”
“Dusty dragged him back. That’s all the sense he has.”
Lon spoke just as though the vagrant were not present. “Lucky for
him he’s got an alibi this time.”
“Is it necessary to insult him after he protected me?” the girl
demanded, eyes flashing. “I’m ashamed of you, Lon.”
He was taken aback. “I reckon it takes more’n that to insult a hobo.”
“Is a man a hobo because he’s looking for work?”
The foreman’s hard gaze took in the man, his white face and soft
hands. “What would he do if he found it?” he asked bluntly.
“You’ve no right to say that,” she flung back. “I think it’s hateful the
way you’re all acting. I tell you he fought for me—after what Father
did to him.”
“Fought for you?” This was news to Lon. His assumption had been
that the young fellow had merely entered a formal protest in order to
clear himself in case retribution followed. “You mean with his fists?”
“Yes—against the thin-faced one. He thrashed him and put me on
my horse and started me home. Then Dusty ropes him and drags
him here on the ground and you come and insult him. He must think
we’re a grateful lot.”
As they looked at the slim, vital girl confronting him with such
passionate and feminine ferocity, the eyes of the foreman softened.
All her life she had been a part of his. He had held her on his knee, a
crowing baby, while her dimpled fingers clung to his rough coat or
explored his unshaven face. He had fished her out of an irrigation
ditch when she was three. He had driven her to school when for the
first time she started on that great adventure. It had been under his
direction that she had learned to ride, to fish, to shoot. He loved her
as though she had been flesh of his flesh and blood of his blood. It
was a delight to him to be bullied by her and to serve her whims.
“I renig,” he said. “Clint never told me the boy done that. I had it
doped out he was just savin’ his own hide. But I’ll take it all back if
it’s like you say. Shake, son.”
The tramp did not refuse to grip the big brown hand thrust at him.
Nor did he accept the proffered alliance. By a fraction of a second he
forestalled the foreman by stooping to knot a broken lace in one of
the gaping shoes.
Cig, who had been edging closer, gave Tug a rancorous look. “I ain’t
forgettin’ this,” he promised. “I’ll get youse good some day for rappin’
on me.”
“He didn’t tell on you. Some of my men brought him here in the
gather like we did you,” Forbes explained.
“Wot’ell youse givin’ me? He rapped. That’s wot he done, the big
stiff. An’ I’ll soitainly get him right for it.”
“That kind of talk ain’t helpin’ you any,” the foreman said. “If you got
any sense, you’ll shut yore trap an’ take what’s comin’.”
“I’ll take it. Don’t youse worry about that. You’d better kill me while
youse are on the job, for I’ll get you, too, sure as I’m a mont’ old.”
Reed drove up in the old car he used for a runabout. He killed the
engine, stepped down, and came up to the group by the porch.
“See you rounded ’em up, Lon.”
“Yep. Found ’em in the cottonwoods acrost the track at Wild Horse.”
The ranchman’s dominant eyes found Tug. “Howcome you here?” he
asked.
The gay-cat looked at him in sullen, resentful silence. The man’s
manner stirred up in the tramp a flare of opposition.
“Dusty brought him here. I want to tell you about that, Dad,” the girl
said.
“Later.” He turned to Tug. “I want a talk with you—got a proposition
to make you. See you later.”
“Not if I see you first,” the ragged nomad replied insolently. “I never
did like bullies.”
The ranchman flushed angrily, but he put a curb on his temper. He
could not afford to indulge it since he was so much in this youth’s
debt. Abruptly he turned away.
“Bring the other two to the barn,” he ordered Forbes. “We’ll have a
settlement there.”
York shuffled forward, in a torment of fear. “See here, mister. I ain’t
got a thing to do with this. Honest to Gawd, I ain’t. Ask Tug. Ask the
young lady. I got respeck for women, I have. You wouldn’t do dirt to
an old ’bo wot never done you no harm, would you, boss?”
His voice was a whine. The big gross man was on the verge of
blubbering. He seemed ready to fall on his knees.
“It’s true, Dad. He didn’t touch me,” Betty said in a low voice to her
father.
“Stood by, didn’t he? Never lifted a hand for you.”
“Yes, but—”
“You go into the house. Leave him to me,” ordered Reed. “Keep this
young man here till I come back.”
Betty knew when words were useless with her father. She turned
away and walked to the porch.
The cowpunchers with their prisoners moved toward the barn. York,
ululating woe, had to be dragged.
Left alone with the tramp called Tug, Betty turned to him a face of
dread. “Let’s go into the house,” she said drearily.
“You’d better go in. I’m taking the road now,” he said in answer.
“But Father wants to see you. If you’ll wait just a little—”
“I have no business with him. I don’t care to see him, now or any
time.” His voice was cold and hard. “Thank you for the lemonade,
Miss Reed. I’ll say good-bye.”
He did not offer his hand, but as he turned away he bowed.
There was nothing more for Betty to say except “Good-bye.”
In a small voice of distress she murmured it.
Her eyes followed him as far as the road. A sound from the barn
drove her into the house, to her room, where she could cover her
ears with the palms of her small brown hands.
She did not want to hear any echo of what was taking place there.
 CHAPTER VIII
A RIFT IN THE LUTE

In the cool of the evening Justin Merrick drove down from the
Sweetwater Dam to the Diamond Bar K ranch. It was characteristic
of him that his runabout was up to date and in perfect condition. He
had an expensive taste in the accessories of life, and he either got
the best or did without.
Hands and face were tanned from exposure to the burning sun of the
Rockies, but he was smooth-shaven and immaculate in the
engineer’s suit which fitted his strong, heavy-set figure so snugly.
He drove with precision, as he did everything else in his well-ordered
life. There was in his strength no quality of impatience or turbulence.
He knew what he wanted and how to get it. That was why he had
traveled so far on the road to success and would go a great way
farther.
To-night he anticipated two pleasant hours with Betty Reed. He
would tell her about the work and how it was getting along, his
difficulties with the sand formation at the head gates and how he was
surmounting them. Even before she spoke, he would know from her
eager eyes that she was giving him the admiration due a successful
man from his sweetheart.
Afterward he would pass to more direct and personal love-making,
which she would evade if possible or accept shyly and reluctantly.
She was wearing his ring, but he doubted whether he had really
stormed the inner fortress of her heart. This uncertainty, and the
assurance that went with it of a precious gift not for the first chance
comer, appealed to his fastidious instinct, all the more that he was
sure she would some day come to him with shining eyes and
outstretched hands.
To-night Merrick found Betty distrait and troubled. Her attention to
the recital of his problems was perfunctory. He was conscious of a
slight annoyance. In spite of his force, Justin was a vain man, always
ready to talk of himself and his achievements in a modest way to an
interested and interesting young woman.
It appeared that her father had had a difficulty with some tramps,
which had eventuated in insolence that had brought upon the
vagrants summary physical punishment. From her account of it,
Justin judged that Reed had not handled the matter very wisely.
There was a way to do such things with a minimum of friction.
But he saw no need of worrying about it. The tramps had been given
what they deserved and the affair was closed. It was like a woman to
hold it heavily on her conscience because one of the ne’er-do-wells
chanced to be young and good-looking.
“If you’d seen him,” Betty protested. “A gentleman by the look of him,
or had been once, fine-grained, high-spirited, and yet so down-and-
out.”
“If he’s down-and-out, it’s his own fault. A man’s never that so long
as he holds to self-respect.”
This was incontrovertibly true, but Betty chose to be irritated. Justin
was so obviously successful. He might have had a little sympathy for
the underdog, she thought. Everybody did not have a square, salient
jaw like his. Weakness was not necessarily a crime.
“He looks as though life had mauled him,” she said. “It’s taken
something vital out of him. He doesn’t care what happens any more.”
“If he can only mooch his three meals a day and enough cash to
keep him supplied with bootleg poison,” the engineer added.
They were walking up to the Three Pines, a rocky bluff from which
they could in the daytime see far down the valley. She stopped
abruptly. If she did not stamp her foot, at least the girl’s manner gave
eloquently the effect of this indulgence.
“He’s not like that at all—not at all. Don’t you ever sympathize with
any one that’s in hard luck?” she cried out, her cheeks glowing with a
suffusion of underlying crimson.
“Not when he lies down under it.”
She flashed at him a look resentful of his complacency. It held, too,
for the first time a critical doubt. There was plenty to like about Justin
Merrick, and perhaps there was more to admire. He got things done
because he was so virile, so dominant. To look at the lines and
movements of his sturdy body, at the close-lipped mouth and
resolute eyes, was to know him a leader of men. But now a
treasonable thought had wirelessed itself into her brain. Had he a
mind that never ranged out of well-defined pastures, that was quite
content with the social and economic arrangement of the world? Did
there move in it only a tight little set of orthodox ideas?
“How do you know he lies down under it?” she asked with spirit.
“How do we know what he has to contend with? Or how he struggles
against it?”
If his open smile was not an apology, it refused, anyhow, to be at
variance with her. “Maybe so. As you say, I didn’t see him and you
did. We’ll let it go at that and hope he’s all you think he is.”
Betty, a little ashamed of her vagrant thoughts, tried to find a
common ground upon which they could stand. “Don’t you think that
men are often the victims of circumstance—that they get caught in
currents that kinda sweep them away?”
“‘I am the captain of my soul,’” he quoted sententiously.
“Yes, you are,” she admitted, after one swift glance that took in the
dogged, flinty quality of him. “But most of us aren’t. Take Dad. He’s
strong, and he’s four-square. But he wouldn’t have gone as far as he
did with these tramps if he hadn’t got carried away. Well, don’t you
think maybe this boy is a victim of ‘the bludgeonings of chance’? He
looked like it to me.”
“We make ourselves,” he insisted. “If the things we buck up against
break us, it’s because we’re weak.”
“Yes, but—” Betty’s protest died away. She was not convinced, and
she made another start. “It seems to me that when I read the new
novelists—Wells, Galsworthy, or Bennett, say—one of the things I
get out of them is that we are modified by our environment, not only
changed by it, but sometimes made the prey of it and destroyed by
it.”
“Depends on how solid on our feet we are,” answered the engineer.
“That’s the plea of the agitator, I know. He’s always wanting to do
impossible things by law or by a social upheaval. There’s nothing to
it. A man succeeds if he’s strong. He fails if he’s weak.”
This creed of the individualist was sometimes Betty’s own, but to-
night she was not ready to accept it. “That would be all very well if
we all started equal. But we don’t. What about a man who develops
tuberculosis, say, just when he is getting going? He’s weak, but it’s
no fault of his.”
“It may or may not be. Anyhow, it’s his misfortune. You can’t make
the world over because he’s come a cropper. Take this young tramp
of yours. I’d like to try him out and show you whether there’s
anything to him. I’d put him on the work and let him find his level.
Chances are he’d drift back to the road inside of a week. When a
man’s down-and-out, it isn’t because he doesn’t get a chance, but
because of some weakness in himself.”
Betty knew that in the case of many this was true. For a year or more
she had been an employer of labor herself. One of the things that
had impressed her among the young fellows who worked for her was
that they did find their level. The unskilled, shiftless, and less reliable
were dropped when work became slack. The intelligent and
energetic won promotion for themselves.
But she did not believe that it was by any means a universal truth.
Men were not machines, after all. They were human beings.
However, she dropped the subject.
“He’s gone, so you won’t have a chance to prove your case,” she
said. “Tell me about the work. How is it going?”
The Sweetwater Dam project had been initiated to water what was
known as the Flat Tops, a mesa that stretched from the edge of the
valley to the foothills. It had been and still was being bitterly opposed
by some of the cattlemen of Paradise Valley because its purpose
was to reclaim for farming a large territory over which cattle had
hitherto ranged at will. Their contention held nothing of novelty. It had
been argued all over the West ever since the first nesters came in to
dispute with the cattle barons the possession of the grazing lands. A
hundred districts in a dozen States had heard the claim that this was
a cattle country, unfit for farming and intensive settlement. Many of
them had seen it disproved.
The opposition of powerful ranching interests had not deterred Justin
Merrick. Threats did not disturb him. He set his square jaw and
pushed forward to the accomplishment of his purpose. As he rode or
drove through the valley, he knew that he was watched with hostile
eyes by reckless cowpunchers who knew that his success would put
a period to the occupation they followed. Two of them had tried to
pick a quarrel with him at Wild Horse on one occasion, and had
weakened before his cool and impassive fearlessness.
But he did not deceive himself. At any hour the anger of these men
might flare out against him in explosive action. For the first time in
his life he was carrying a revolver.
Clint Reed was a stockholder and a backer of the irrigation project.
He owned several thousand acres on the Flat Tops, and it was
largely on account of his energy that capital had undertaken the
reclamation of the dry mesa.
The head and front of the opposition was Jake Prowers, who had
brought down from early days an unsavory reputation that rumor
said he more than deserved. Strange stories were whispered about
this mild-mannered little man with the falsetto voice and the skim-
milk eyes. One of them was that he had murdered from ambush the
successful wooer of the girl he wanted, that the whole countryside
accepted the circumstantial evidence as true, and in spite of this he
had married the young widow within a year and buried her inside of
two. Nesters in the hills near his ranch had disappeared and never
been seen again. Word passed as on the breath of the winds that
Prowers had dry-gulched them. Old-timers still lived who had seen
him fight a duel with two desperadoes on the main street of Wild
Horse. He had been carried to the nearest house on a shutter with
three bullets in him, but the two bad men had been buried next day.
The two most important ranchmen in the valley were Clint Reed and
Jake Prowers. They never had been friendly. Usually they were
opposed to each other on any public question that arose. Each was
the leader of his faction. On politics they differed. Clint was a
Republican, Jake a Democrat. There had been times when they had
come close to open hostilities. The rivalry between them had
deepened to hatred on the part of Prowers. When Reed announced
through the local paper the inception of the Sweetwater Dam project,
his enemy had sworn that it should never go through while he was
alive.
Hitherto Prowers had made no move, but everybody in the district
knew that he was biding his time. Competent engineers of the
Government had passed adversely on this irrigation project. They
had decided water could not be brought down from the hills to the
Flat Tops. Jake had seen the surveys and believed them to be
correct. He was willing that Reed and the capitalists he had
interested should waste their money on a fool’s dream. If Justin
Merrick was right—if he could bring water through Elk Creek Cañon
to the Flat Tops—it would be time enough for Prowers to strike.
Knowing the man as he did, Clint Reed had no doubt that, if it
became necessary in order to defeat the project, his enemy would
move ruthlessly and without scruple. It was by his advice that Justin
Merrick kept the dam guarded at night and carried a revolver with
him when he drove over or tramped across the hills.
 CHAPTER IX
UNDER FIRE

All day the faint far whir of the reaper could have been heard from
the house of the Diamond Bar K ranch. The last of the fields had
been cut. Much of the grain had been gathered and was ready for
the thresher.
The crop was good. Prices would be fair. Clint Reed rode over the
fields with the sense of satisfaction it always gave him to see
gathered the fruits of the earth. His pleasure in harvesting or in
rounding-up beef steers was not only that of the seller looking to his
profit. Back of this was the spiritual gratification of having been a
factor in supplying the world’s needs. To look at rippling wheat
ripening under the sun, to feed the thresher while the fan scattered a
cloud of chaff and the grain dropped into the sacks waiting for it,
ministered to his mental well-being by justifying his existence. He
had converted hundreds of acres of desert into fertile farm land. All
his life he had been a producer of essentials for mankind. He found
in this, as many farmers do, a source of content. He was paying his
way in the world.
To-day Reed found the need of vindication. He was fonder of Betty
than he was of anything or anybody else in the world, and he knew
that he was at the bar of her judgment. She did not approve of what
he had done. This would not have troubled him greatly if he had
been sure that he approved of it himself. But like many willful men he
sometimes had his bad quarter of an hour afterward.
It was easy enough to make excuses. The Diamond Bar K had been
troubled a good deal by vagrants on the transcontinental route. They
had robbed the smokehouse only a few weeks before. A gang of
them had raided the watermelon patch, cut open dozens of green
melons, and departed with such ripe ones as they could find.
Naturally he had been provoked against the whole breed of them.
But he had been too hasty in dealing with the young scamp he had
thrashed. Clint writhed under an intolerable sense of debt. The boy
had fought him as long as he could stand and take it. He had gone
away still defiant, and had rescued Betty from a dangerous situation.
Dragged back at a rope’s end to the ranch by the luckless Dusty, he
had scornfully departed before Reed had a chance to straighten out
with him this added indignity. The owner of the Diamond Bar K felt
frustrated, as though the vagabond had had the best of him.
He was not even sure that the severe punishment he had meted out
to the other tramps had been wise. The man Cig had endured the
ordeal unbroken in spirit. His last words before he crept away had
been a threat of reprisal. The fellow was dangerous. Clint read it in
his eyes. He had given orders to Betty not to leave the ranch for the
next day or two without an escort. Yet he still felt uneasy, as though
the end of the matter had not come.
It was now thirty hours since he had last seen the hoboes. No doubt
they were hundreds of miles away by this time and with every click of
the car wheels getting farther from the ranch.
He rode back to the stable, unsaddled, and walked to the house.
Betty was in the living-room at the piano. She finished the piece,
swung round on the stool, and smiled at him.
“Everything fine and dandy, Dad?”
His face cleared. It was her way of telling him that she was ready to
forgive and be forgiven.
“Yes.” Then, abruptly, “Reckon I get off wrong foot first sometimes,
honey.”
He was in a big armchair. She went over to him, sat down on his
knees, and kissed him. “’S all right, Dad,” she nodded with an effect
of boyish brusqueness. Betty, too, had a mental postscript and
expressed it. “It’s that boy. Nothing to do about it, of course. He
wouldn’t let me do a thing for him, but—Oh, well, I just can’t get him
off my mind. Kinda silly of me.”