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Some Notations
ADF Annuity discount factor MVA Market value added
APR Annual percentage rate MVR Market value at risk
APV Adjusted present value NOPAT Net operating profit after tax
bU Levered beta (also called equity or NOPLAT Net operating profit less adjusted tax
market beta) NPV Net present value
bL Unlevered beta (also called asset beta) P Price of a bond, a stock, or a put option
C Call price PBR Price-to-book ratio
CAPM Capital asset pricing model PI Profitability index
CAPEX Capital expenditures PER Price earnings ratio
CF Cash flow PPP Purchasing power parity
CFE Cash flow to equity holders PV Present value
CML Capital market line rij Correlation coefficient between asset i
CP Coupon payment (of a bond) and asset j returns
Cov 1 Ri, Rj 2 Covariance between asset i and asset j RF Risk-free rate
returns RM Return on the market portfolio
D Debt value ROCE Return on capital employed
DCF Discounted cash flow ROE Return on equity
D Option’s delta or hedge ratio ROIC Return on invested capital
DDM Dividend discount model SGR Self-sustainable growth rate
DF Discount factor si Standard deviation of asset i returns
DPS Dividend per share (volatility)
E Equity value s2i Variance of asset i returns (variability)
EAT Earnings after tax sij Covariance between asset i and asset j
EBIT Earnings before interest and tax returns
EBITDA Earnings before interest, tax, SML Security market line
depreciation and amortization T Time in years
EIL Efficient investment line TC Corporate tax rate
EPS Earnings per share TV Terminal value
E 1 Ri 2 Expected return of asset i VE Value of the firm’s equity (same as E)
EV Enterprise value VL Value of the firm with debt (levered
EVA® Economic value added value)
F Face value of a bond VU Value of the firm without debt
(unlevered value)
FCF Free cash flow
Var 1 Ri 2 Variance of asset i returns
IPO Initial public offering
(same as s2i )
ITS Interest tax shield
WCR Working capital requirement
kD Cost of debt
WACC Weighted average cost of capital
kE Cost of equity
X Exercise or strike price of an option
LBO Leverage buyout
y Yield to maturity (of a bond)
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Some Useful Formulas
1. Discount factor (Chapter 2, equation 2.3)
Value of $1 to be received at time T, discounted to the present at the rate k
$1 $1 T
DFT,k 5 5¢ ≤ 5 $1 3 1 1 1 k 2 2T
1 11k 2 T
11k
2. Present value (Chapter 2)
Value today of a T-year cash-flow stream discounted at rate k
PV 5 3 CF1 3 DF1,k 4 1 . . . 3 CFt 3 DFt,k 4 1 . . . 1 3 CFT 3 DFT,k 4

3. Present value of a perpetuity (Chapter 2, equation 2.6)
The present value of an infinite stream of identical cash flows discounted at rate k
CF
PV 5
k
4. Present value of a constant growing perpetuity (Chapter 2, equation 2.9)
Present value, at rate k, of a perpetuity growing at the constant rate g where the
cash flow at the end of the first year is CF1
CF1
PV 5 with k . g
k2g
5. Present value of an annuity (Chapter 2, equation 2.11)

Present value of a T-year annuity at a rate k with a cash flow CF
PV 5 CF 3 ADFT,k with
1 1
ADFT,k 5 B1 2 R
k 1 11k 2 T
6. Sharpe ratio of asset i (Chapter 3, equation 3.8)
E 1 Ri 2 2 RF
Sharpe ratio of asset i 5
si
7. Beta coefficient of stock i (Chapter 3, equation 3.11)
Cov 1 Ri, RM 2 riMsisM si

5 bi 55 riM ¢ ≤
Var 1 RM 2 2
sM sM
8. Capital asset pricing model (Chapter 3, equation 3.13a, Chapter 10,
equation 10.11a and Chapter 12, equation 12.10)
E 1 Ri 2 5 RF 1 3 E 1 RM 2 2 RF 4 b i
9. Invested capital (Chapter 4, equation 4.5)
Invested capital 5 Cash 1 Working capital requirement 1 Net fixed assets
10. Capital employed (Chapter 4, equation 4.6)

Capital employed 5 Short-term debt 1 Long-term debt 1 Owners’ equity
Some Useful Formulas
11. Working capital requirement (Chapter 4, equation 4.7)
WCR 5 3 Accounts receivable 1 Inventories 1 Prepaid expenses 4

2 3 Accounts payable 1 Net accruals 4
12. Earnings before interest, tax, depreciation, and amortization (Chapter 4,
equation 4.10)
EBITDA 5 EBIT 1 Depreciation expense 1 Amortization expense
13. Free cash flow (Chapter 4, equation 4.15)
FCF 5 EBIT 1 1 2 Tc 2 1 Depreciation expense
2 DWCR 2 Capital expenditures 1 net of disposals 2
14. Return on equity (Chapter 6, equation 6.1)
Earnings after tax
ROE 5
Owners’ equity
15. Return on invested capital before tax (Chapter 6, equation 6.4)
EBIT EBIT Sales

ROICBT 5 5 3
Invested capital Sales Invested capital
16. The structure of a firm’s return on equity (Chapter 6, equation 6.9)
EBIT Sales EBT Invested capital EAT

ROE 5 3 3 3 3
Sales Invested capital EBIT Owners’ equity EBT
17. Self-sustainable growth rate (Chapter 6, equation 6.12)
SGR 5 Profit retention rate 3 Return on equity
18. Net present value (Chapter 7)

CF1 CF2 CFt CFT
NPV 1 k,T 2 5 2CF0 1 1 1 ... 1 1 ... 1
1 11k 2 1 1 11k 2 2 1 11k 2 t 1 11k 2 T
5 2CF0 1 a
T
CFt
t5 1 1 11k 2
t
19. Bond price (Chapter 10, equation 10.2)

CP1 CP2 CPT 1 F
1 P5
1 ... 1
1 11y 2 1 11y 2 2
1 11y 2 T
20. Share price (Chapter 10, equation 10.9)
DPS1 DPS2 DPSt
P5 1 1 ... 1 1 ...
1 11kE 2 1 11kE 2 2 1 11kE 2 t
21. Constant dividend growth model (Chapter 10, equation 10.10)

DPS1
P5
kE 2 g
22. Enterprise value and Equity value (Chapter 10, equation 10.13)
Enterprise Value (EV) 5 Equity Value 1 Debt 2 Cash and other financial assets
Equity Value 1 VE 2 5 Enterprise Value 1 EV 2 1 Cash 2 Debt
23. Equity (levered) beta (Chapter 12, equation 12.6)
Debt
bequity 5 basset B1 1 R
Equity
24. Weighted average cost of capital (Chapter 12, equation 12.12)

D E
WACC 5 kD 1 1 2 TC 2 1 kE
E1D E1D
25. Interest tax shield (Chapter 13, equation 13.3)
ITS 5 TC 3 kD 3 D
26. Market value of a levered firm (Chapter 13, equation 13.4)

VL 5 VU 1 PVITS
27. Market value at risk (Chapter 15, equation 15.1)
MVR 5 3 Reduction in the firm’s value if the risk will occur 4

3 3 Probability that the risk will occur 4
28. Put-call parity relationship (Chapter 16, equation 16.5)
P0 5 C0 1 Xe2R T 2 S0 F
29. Black-Scholes option pricing formula (Chapter 16, equation 16.6 and 16.7)
C0 1 call option 2 5 S0N 1 d1 2 2 Xe2R TN 1 d2 2 F
P0 1 put option 2 5 Xe2R T 3 1 2 N 1 d2 2 4 2 S0 3 1 2 N 1 d2 2 4

F
30. Market value added (Chapter 18, equation 18.1)
Market value added 1 MVA 2 5 Market value of capital 2 Capital employed
31. Return on invested capital (Chapter 18)

NOPAT EBIT 1 1 2 TC 2
ROIC 5 5
Invested capital Invested capital
32. Economic value added (Chapter 18, equation 18.6)
EVA 5 3 Return spread 4 3 Invested capital 5 3 ROIC 2 WACC 4 3 Invested capital
Finance For Executives
Managing for Value Creation
Finance For Executives
Managing for Value Creation
sixth Edition
Gabriel Hawawini
INSEAD
Claude Viallet
INSEAD
Australia • Brazil • Mexico • Singapore • United Kingdom • United States
Finance for Executives: Managing for © 2019, Cengage Learning EMEA
Value Creation, Sixth Edition
WCN: 02-300
Gabriel Hawawini & Claude Viallet
ALL RIGHTS RESERVED. No part of this work covered by the
copyright herein may be reproduced or distributed in any form or
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A catalogue record for this book is available from the British Library.
ISBN: 978-1-4737-4924-5
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Print Number: 01 Print Year: 2019
To our spouses, children and grandchildren, with love and gratitude.
GH and CV, 2018
This edition of Finance for Executives is dedicated to the memory of

Claude Viallet, my friend, colleague and co-author.
Gabriel Hawawini, 2019
Brief Contents
part i Financial Concepts and Techniques 1
chapter 1 Financial Management and Value Creation: An Overview 1
chapter 2 The Time Value of Money 31
chapter 3 Risk and Return 53
PART ii Assessing Business Performance 99

chapter 4 Interpreting Financial Statements 99
chapter 5 Analyzing Operational Efficiency and Liquidity 153
chapter 6 Analyzing Profitability, Risk, and Growth 189
PART iii Making Investment Decisions 227

chapter 7 Using the Net Present Value Rule to Make Value-Creating
Investment Decisions 227
chapter 8 Alternatives to the Net Present Value Rule 261
chapter 9 Identifying and Estimating a Project’s Cash Flows 287
PART iV Making Financing Decisions 315

chapter 1 0 Valuing Bonds and Stocks 315
chapter 1 1 Raising Capital and Paying Out Cash 359
chapter 1 2 Estimating the Cost of Capital 411
chapter 1 3 Designing a Capital Structure 445
PART V Making Business Decisions 487

chapter 1 4 Valuing and Acquiring a Business 487
chapter 1 5 Managing Corporate Risk 531
chapter 1 6 Understanding Forward, Futures, and Options and Their
ontribution to Corporate Finance 555
C
chapter 1 7 Making International Business Decisions 609
chapter 1 8 Managing for Value Creation 653
Answers to Self-Test Questions 691
Glossary 741
Credits 763
Index 765
vi
Contents
PART i Financial Concepts and Techniques 1

chapter 1 Financial Management and Value Creation: An Overview 1
The Key Question: Will Your Decision Create Value? 2
The Importance of Managing for Value Creation 3
The Saturn Story 4
The Fundamental Finance Principle 5
Measuring Value Creation with Net Present Value 5
Only Cash Matters 6
Discount Rates 6
A Proposal’s Cost of Capital 7
Applying the Fundamental Finance Principle 8
The Capital Budgeting Decision 8
The Payout Policy 10
The Capital Structure Decision 11
The Business Acquisition Decision 11
The Foreign Investment Decision 12
The Role of Financial Markets 12
The Equity Market 13
The Vioxx Recall 14
External Versus Internal Financing 15
The Business Cycle 15
HLC’s Financial Statements 17
The Balance Sheet 17
A Variant of the Standard Balance Sheet: The Managerial
Balance Sheet 19
The Income Statement 20
How Profitable Is the Firm? 21
The Profitability of Equity Capital 21
The Profitability of Invested Capital 22
How Much Cash Has the Firm Generated? 22
Sources and Uses of Cash 23
The Statement of Cash Flows 23
How Risky Is the Firm? 23
Has the Firm Created Value? 25
The Role of the Chief Financial Officer 26
vii
viii Finance For Executives
Key Points 26
Further Reading 27
Self-Test Questions 27
chapter 2 The Time Value of Money 31

Present Values and Future Values 32
Compounding 33
Discounting 34
Using a Financial Calculator to Solve Time Value of
Money Problems 35
Using a Spreadsheet to Solve Time Value of
Money Problems 36
Interest Rate Quotation and Calculation 36
The Annual Percentage Rate Versus the Effective Annual Rate 37
Nominal Versus Real Rates 38
The Present Value of a Stream of Future Cash Flows 38
The Net Present Value (NPV) Rule 39
The Internal Rate of Return (IRR) Rule 39
The Present Value of a Perpetual Cash-Flow Stream 40
The Present Value of a Growing Perpetuity 41
The Present Value of a Standard Annuity 42
The Present Value of a Growing Annuity 44
The Future Value of an Annuity 46
Key Points 47
Appendix 2.1 Proof of Formula 2.9 and Formula 2.6 49

Further Reading 49
Review Questions 50
chapter 3 Risk and Return 53

Measures of Return 54
Realized Returns 54
Expected Return 55
Annualized Returns 55
Measures of Risk 55
Measuring Risk with the Variance of Returns 55
Measuring Risk with the Standard Deviation of Returns 56
Variance versus Standard Deviation 56
Annualized Measures of Risk 56
Return Distributions 57
Contents ix
Mean-Variance Analysis 57
Attitudes Toward Risk 60
Evidence from Financial Markets 61
Combining Two Stocks into a Portfolio 61
Portfolio Expected Return 63
Portfolio Risk and Correlations 63
Diversification Can Reduce Risk and Raise Return 65
The Opportunity Set of a Two-Stock Portfolio 65
The Optimal Portfolio of a Risk-Averse Investor 68
Changes in the Correlation Coefficient 68
Combining More Than Two Stocks into a Portfolio 68
Portfolio Expected Return 69
Portfolio Risk and Diversification 69
Portfolio Diversification in Practice 72
Firm-Specific Risk versus Market Risk 73
The Opportunity Set with More Than Two Stocks 74
Optimal Portfolios when there is a Riskless Asset 75
The Efficient Investment Line 75
The Sharpe Ratio 76
Making Optimal Investment Choices 77
The Market Portfolio and the Capital Market Line 79
The Expected Return of the Market Portfolio 79
Proxies for the Market Portfolio 80
The Sharpe Ratio and the Efficiency of the Market Portfolio 80
The Capital Market Line 80
Modern Investment Management: Allocation Beats Selection 82
A Closer Look at Systematic Risk 83
Beta and the Market Model 84
Calculating Beta 84
The Properties of Beta 85
Estimated Stock Betas 85
Portfolio Beta 86
The Capital Asset Pricing Model 87
The Expected Return of an Individual Stock 87
Using the CAPM to Estimate a Company’s Cost of Equity Capital 88
Using the CAPM to Evaluate Investment Performance 89
Using the CAPM to Test the Informational Efficiency of Stock
Markets 90
Key Points 91
Further Reading 92
Appendix 3.1 How to Get the SML Equation 93

Review Questions 95
x Finance For Executives
PART ii Assessing Business Performance 99

chapter 4 Interpreting Financial Statements 99
Financial Accounting Statements 99
The Balance Sheet 100
Current or Short-Term Assets 101
Noncurrent or Fixed Assets 105
Current or Short-Term Liabilities 107
Noncurrent Liabilities 108
Owners’ Equity 110
The Managerial Balance Sheet 110
Working Capital Requirement 111
The Income Statement 114
Net Sales or Turnover 116
Gross Profit 116
Operating Profit 117
Earnings Before Interest and Tax (EBIT) 117
Earnings Before Tax (EBT) 118
Earnings After Tax (EAT) 118
Earnings Before Interest, Tax, Depreciation, and Amortization
(EBITDA) 118
Reconciling Balance Sheets and Income Statements 119
The Structure of the Owners’ Equity Account 120
Preparing a Statement of Cash Flows 122
Net Cash Flow from Operating Activities 123
Net Cash Flow from Investing Activities 125
Net Cash Flow from Financing Activities 126
Problems with the Statement of Cash Flows 127
Free Cash Flow 128
Key Points 129
Appendix 4.1 Obtaining the Net Cash Flow from Operating Activities Using
Balance Sheet and Income Statement Accounts 132
Measuring Cash Inflow from Sales 132
Measuring Cash Outflow from Operating Activities 132
Cash Outflow from Purchases 132
Cash Outflow from SG&A and Tax Expenses 133
Cash Outflow from Net Interest Expense 134
Net Cash Flow from Operating Activities 134
Contents xi
Appendix 4.2 Specimen Financial Statements 136

The GlaxoSmithKline (GSK) Financial Statements 136
GSK’s Balance Sheets and Managerial Balance Sheets 136
GSK’s Balance Sheets 136
Gsk’s Managerial Balance Sheets 139
GSK’s Income Statements 140
GSK’s Statements of Cash Flows 142
Further Reading 144
Review Questions 148
chapter 5 Analyzing Operational Efficiency and Liquidity 153

The Structure of the Managerial Balance Sheet 154
The Three Components of a Firm’s Invested Capital 154
The Two Components of a Firm’s Capital Employed 158
The Structure of OS Distributors’ Managerial Balance Sheet 158
The Matching Strategy 158
A Measure of Liquidity Based on the Funding Structure of Working
Capital Requirement 160
Improving Liquidity through Better Management of the
Operating Cycle 163
The Effect of the Firm’s Economic Sector on Its Working Capital
Requirement 163
The Effect of Managerial Efficiency on Working Capital Requirement 165
The Effect of Sales Growth on Working Capital Requirement 167
Traditional Measures of Liquidity 168
Net Working Capital 168
The Current Ratio 170
The Acid Test or Quick Ratio 171
Key Points 171
A p p e n d i x 5 . 1 Financing Strategies 173
A p p e n d i x 5 . 2 The GlaxoSmithKline Liquidity and Operational Efficiency 176

Gsk’s Liquidity Position 176
Gsk’s Management of the Operating Cycle 177
Further Reading 179
xii Finance For Executives
chapter 6 Analyzing Profitability, Risk, and Growth 189

Measures of Profitability 190
Return on Equity 190
Measuring Return on Equity 190
The Effect of Operating Decisions on ROE 191
The Effect of Financing Decisions on Return on Equity 197
The Incidence of Taxation on Return on Equity 199
Putting It All Together: The Structure of a Firm’s Profitability 200
The Structure of ROE Across Industries 202
Other Measures of Profitability 203
Earnings Per Share (EPS) 203
The Price-to-Earnings Ratio (P/E) 203
The Market-to-Book Ratio 204
Financial Leverage and Risk 204
How Does Financial Leverage Work? 205
Two Related Caveats: Risk and the Ability to Create Value 206
Self-Sustainable Growth 207
Key Points 211
A p p e n d i x 6 . 1 Glaxosmithkline�s Profitability 213

GSK�s Profitability Structure 213
Return on Equity 213
The Effect of Operating Margin on GSK’s Operating Profitability 213
The Effect of Invested Capital Turnover on GSK’s Operating
Profitability 217
The Effect of GSK’s Financial Policy on Its Return on Equity 218
The Effect of Taxation on GSK’s Return on Equity 219
Further Reading 219
PART iii Making Investment Decisions 227

chapter 7 Using the Net Present Value Rule to Make Value-Creating
Investment Decisions 227
The Capital Investment Process 228
Would You Buy This Parcel of Land? 230
The Alternative Investment 230
The Opportunity Cost of Capital 231
The Net Present Value Rule 232
A One-Period Investment 232
A Two-Period Investment without an Intermediate
Cash Flow 234
Contents xiii
A Two-Period Investment with an Intermediate Cash Flow 235

Multiple-Period Investments 236
Applying the Net Present Value Rule to a Capital Investment
Decision 237
Why the NPV Rule is a Good Investment Rule 238
NPV Is a Measure of Value Creation 239
NPV Adjusts for the Timing of the Project’s Cash Flows 240
NPV Adjusts for the Risk of the Project’s Cash Flows 240
NPV Is Additive 244
Special Cases of Capital Budgeting 246
Comparing Projects of Unequal Size 246
Comparing Projects with Unequal Life Spans 248
Limitations of the Net Present Value Criterion 251
Managerial or Real Options Embedded in Investment Projects 251
Dealing with Managerial Options 253
Key Points 254
Further Reading 256
chapter 8 Alternatives to the Net Present Value Rule 261

The Payback Period 261
The Payback Period Rule 262
Why Do Managers Use the Payback Period Rule? 265
The Discounted Payback Period 267
The Discounted Payback Period Rule 268
The Discounted Payback Period Rule versus the Ordinary Payback
Period Rule 269
The Internal Rate of Return 270
The IRR Rule 271
The IRR Rule May Be Unreliable 273
Why Do Managers Usually Prefer the IRR Rule to the NPV Rule? 276
The Profitability Index 277
The Profitability Index Rule 277
Use of the Profitability Index Rule 278
The Average Accounting Return 279
The Average Accounting Return Rule 280
Key Points 280
Further Reading 282
xiv Finance For Executives
chapter 9 Identifying and Estimating a Project’s Cash Flows 287

The Actual Cash-Flow Principle 287
The With/Without Principle 288
The Designer Desk Lamp Project 290
Identifying a Project’s Relevant Cash Flows 292
Sunk Costs 292
Opportunity Costs 293
Costs Implied by Potential Sales Erosion 293
Allocated Costs 294
Depreciation Expense 294
Tax Expense 294
Financing Costs 295
Inflation 296
Estimating a Project’s Relevant Cash Flows 297
Measuring the Cash Flows Generated By a Project 298
Estimating the Project’s Initial Cash Outflow 299
Estimating the Project’s Intermediate Cash Flows 303
Estimating the Project’s Terminal Cash Flow 304
Should SMC Launch the New Product? 305
Sensitivity of the Project’s NPV to Changes in the Lamp Price 306
Sensitivity of NPV to Sales Erosion 306
Key Points 307
Further Reading 308
PART iV Making Financing Decisions 315

chapter 1 0 Valuing Bonds and Stocks 315
What Are Bonds and Common Stocks? 316
Bond Features and Terminology 316
Common Stock Features and Terminology 317
The Discounted Cash Flow (DCF) Model 318
Valuing Bonds 320
Finding the Price of a Bond when its Yield Is Known 320
How Changes in Yield Affect Bond Prices 321
Bond Price versus Face Value 322
Finding the Yield of a Bond When Its Price Is Known 322
The Market Yield of a Bond Is the Cost of Debt to the Firm 323
Price Quotation and Yield Conventions 323
The Case of Zero-Coupon Bonds 324
The Case of Perpetual Bonds 326
A Closer Look at Bond Yields snd Risk 327
Risk Is the Major Determinant of a Bond’s Yield 327
Credit Risk, Credit Ratings, and Credit Spreads 327
Contents xv
The Term Structure of Interest Rates 329

Finding the Price and the Yield of a Bond If the
Spot Rates are Known 333
Interest-Rate Risk 334
Duration as a Measure of Interest-Rate Risk 335
Valuing Common Stocks 336
Valuation Based on the Dividend-Discount Model (DDM) 336
Valuation Based on Discounted Free Cash Flows 339
Valuing PEC with the Discounted Free Cash Flow Model 341
Valuation Based on Discounted Cash Flows to Equity Holders 343
Comparing the Three Discounted Cash Flow Models 345
Valuation Based on Comparable Firms 345
Direct Valuation of a Firm’s Equity Based on the
Price-to-Earnings Ratio 346
Direct Valuation of a Firm’s Equity Based on the Price-to-Book
Ratio 347
Indirect Valuation of a Firm’s Equity Based on the EV-to-EBITDA
Ratio 347
Key Points 348
A p p e n d i x 1 0 . 1 The Properties of Duration 350

Further Reading 353
chapter 1 1 Raising Capital and Paying Out Cash 359

Estimating the Amount of Required External Funds 360
The Financial System: Its Structure and Functions 364
Direct Financing 364
Indirect or Intermediated Financing 364
Securities Markets 367
How Firms Issue Securities 371
Private Placement 371
Public Offerings 371
Raising Debt Capital 375
Borrowing through Bank Loans 376
Borrowing through Lease Agreements 376
Borrowing by Issuing Short-Term Securities 379
Borrowing by Issuing Corporate Bonds 379
Raising Equity Capital 383
Preferred Stocks 383
Tracking Stock 385
Equity Warrants 385
Contingent Value Rights 385
Distributing Cash to Shareholders 386
Observed Payout Policies 386
xvi Finance For Executives
How and Why Firms Pay Dividends and Buy Back their Shares 390
How Firms Pay Dividends 391
How Firms Repurchase their Shares 391
Differences Between Dividend Payments and Share Repurchases 392
Does a Firm Payout Policy Affect Its Share Price and the Wealth of Its
Shareholders? 394
Paying an Immediate Special Dividend of $250 Million 396
Buying Back $250 Million of Shares in the Open Market 397
Issuing $100 Million of New Equity to Pay an Immediate Dividend of
$350 Million 398
Investing $250 Million in a Project 399
Payout Policy Is Irrelevant in a Perfect Market Environment as Long as the
Firm’s Investing and Financing Policies do not Change 399
Payout Policy with Market Imperfections 400
Key Points 402
Further Reading 405
chapter 1 2 Estimating the Cost of Capital 411

Identifying Proxy or Pure-Play Firms 412
Estimating the Cost of Debt 413
Estimating the Cost of Equity 415
Estimating the Cost of Equity Using the Dividend-Discount Model 415
Estimating the Cost of Equity Using the Capital Asset Pricing Model 417
Estimating the Cost of Capital of a Firm 426
What Is a Firm’s Cost of Capital? 426
The Firm’s Target Capital Structure 427
The Firm’s Costs of Debt and Equity 429
Summary of the Firm’s WACC Calculations 430
Estimating the Cost of Capital of a Project 430
The Project’s Risk Is Similar to the Risk of the Firm 430
The Project’s Risk Is Different from the Risk of the Firm 431
Three Mistakes to Avoid When Estimating a Project’s Cost of
Capital 434
Key Points 438
Further Reading 439
chapter 1 3 Designing a Capital Structure 445

The Capital Structure Decision in a World without Corporate Income
Tax and Financial Distress Costs 446
Effects of Borrowing on the Firm’s Profitability (No Corporate Income Tax
and No Financial Distress Costs) 446
Contents xvii
Understanding the Trade-Off Between Profitability and Risk 449

Effect of Borrowing on the Value of the Firm’s Assets and Its Share Price
(No Corporate Income Tax and No Financial Distress Costs) 450
Effect of Borrowing on the Firm’s Cost of Capital (No Corporate Income
Tax and No Financial Distress Costs) 453
The Capital Structure Decision in a World with Corporate Income Tax
but without Financial Distress Costs 455
Effect of Borrowing on the Value of a Firm’s Assets (with Corporate
Income Tax and No Financial Distress Costs) 456
Effect of Borrowing on the Firm’s Market Value of Equity (with Corporate
Income Tax and No Financial Distress Costs) 460
Effect of Borrowing on the Firm’s Share Price (with Corporate Income Tax
Effect of Borrowing on the Cost of Capital (with Corporate Income Tax
The Capital Structure Decision when Financial Distress is
Costly 464
Formulating a Capital Structure Policy 467
A Closer Look at the Trade-Off Model of Capital Structure 467
Factors Other Than Taxes That May Favor Borrowing 470
Factors Other Than Financial Distress Costs That May Discourage
Borrowing 473
Is There a Preference for Retained Earnings? 475
Putting It All Together 476
Key Points 479
A p p e n d i x 1 3 . 1 Capital Structure and Systematic Risk (Beta) 481

How to Extract Unlevered Betas from Levered Betas 481
Case 1: The Debt-to-Equity Ratio (D/E) is Constant
Over Time 482
Case 2: The Amount of Debt (D) is Constant Over Time 482
Which Formula Should Be Used to Get Unlevered Betas? 483
Further Reading 484
PART V Making Business Decisions 487

chapter 1 4 Valuing and Acquiring a Business 487
Alternative Valuation Methods 488
Valuing a Firm’s Equity Using Comparable Firms 489
Direct Estimation of a Firm’s Equity Value Based on the Equity Value of
Comparable Firms 492
Indirect Estimation of a Firm’s Equity Value Based on the Enterprise
Value of Comparable Firms 494
xviii Finance For Executives
Valuing a Firm’s Business Assets and Equity Using the Discounted Cash
Flow (DCF) Method 496
Estimation of OS Distributors’ Enterprise and Equity Values 497
Step 1: Determination of the Length of the Forecasting Period 498
Step 2: Estimation of the Free Cash Flow from Business Assets 498
Step 3: Estimation of the Weighted Average Cost of Capital 502
Step 4: Estimation of the Terminal Value of Business Assets at
the End of Year 5 503
Step 5: Estimation of the DCF Value of Business Assets (Enterprise Value) 504
Step 6: Estimation of the DCF Value of Equity 504
Comparison of DCF Valuation and Valuation by Comparables 505
Estimating the Acquisition Value of OS Distributors 505
Identifying the Potential Sources of Value Creation in an Acquisition 505
Why Conglomerate Mergers Are Unlikely to Create Lasting Value Through
Acquisitions 508
The Acquisition Value of OS Distributors’ Equity 510
Estimating the Leveraged Buyout Value of OS Distributors 514
Estimating the Leveraged Buyout Value of Business Assets Using the
Adjusted Present Value Method (the APV Method) 516
Will OS Distributors Be Able to Service Its Debt? 520
Key Points 523
Further Reading 525
chapter 1 5 Managing Corporate Risk 531

What Is Risk? 532
Why Should Firms Manage Risk? 533
Risk Management Can Reduce Corporate Income Tax Payments 534
Risk Management Can Lower the Cost of Protection Against Risk 534
Risk Management Can Lower Financial Distress Costs 534
Risk Management Can Provide Clearer Information to Investors About the
Firm’s Core Activities 534
Risk Management Can Lower Agency Costs 534
Corporate Risk Management 535
Risk Netting 535
Cost Savings 535
Risk Policy 536
Risk Learning 536
The Risk Management Process 536
Step 1: Risk Identification 537
Step 2: Risk Measurement 545
Step 3: Risk Prioritization 546
Step 4: Risk Policy 547
Step 5: Risk Monitoring 551
Contents xix
Key Points 551

Further Reading 552
chapter 1 6 Understanding Forward, Futures, and Options and Their

Contribution to Corporate Finance 555
Forward Contracts 556
Price Risk 556
Counterparty Risk 556
Liquidity Risk 557
Futures Contracts and Markets 557
How Futures Markets Mitigate Counterparty Risk 557
How Futures Markets Mitigate Liquidity Risk 558
Available Futures Markets and Contracts 559
Hedging Risk with Futures Contracts 559
The Pricing of Forward and Futures Contracts 562
The Relationship Between the Spot Price and the Forward Price 562
The Relationship Between the Expected Spot Price and the Forward
Price 565
Option Contracts 566
Option Contracts Defined 567
Over-The-Counter (OTC) Options Versus Traded Options 567
European versus American Options 567
Option Buyers and Option Writers 568
Call Options 568
Put Options 571
The Put-Call Parity Relationship 574
Getting Option Prices with the Black and Scholes Formula 577
The Price of a European Call on a Non-Dividend-Paying Stock 577
The Price of a European Put on a Non-Dividend-Paying Stock 577
Using a Spreadsheet to Calculate the Price of European Options 577
The Price of European Options on Dividend-Paying Stocks 579
The Price of American Options 579
Response of Option Prices to Changes in Input Values 581
Implied Volatility 582
How Good Is the Black-Scholes Model? 583
Delta: A Measure of the Sensitivity of Option Prices to Changes in the
Underlying Stock Price 583
An Investment in an Option Is Always Riskier Than the Same Investment
in the Underlying Stock 584
Option-Based Investment Strategies 585
Speculating on a Rise in Stock Price with Naked Calls 585
Hedging Against a Drop in Stock Price with Protective Puts 585
Insuring Equity Portfolios 587
Writing Covered Calls to Generate Income 587
xx Finance For Executives
Collars: Covered Calls with Protective Puts 587

Hedging Stock Price Volatility with Long Straddles 587
Arbitraging Option Prices with Money Spreads or Time Spreads 588
Securities with Option Features 588
Equity as a Call Option on the Firm's Assets 588
Corporate Bonds As Risk-Free Bonds and Short Puts on the Firm’s
Assets 591
Collateralized Loans 591
Right Issues, Warrants and Contingent Value Rights 591
Callable and Convertible Bonds 592
Real Options and Strategic Investment Decisions 592
Expanding Abroad 593
Calculating the Project’s NPV with the Option Value 595
Discussion 596
Different Types of Real Options Embedded in Projects 597
Key Points 597
A p p e n d i x 1 6 . 1 The Binomial Option Pricing Model 601

Creating a Riskless Covered Call Position 601
Finding the Call Price Based on the Riskless Covered Call Position 602
Further Reading 602
chapter 1 7 Making International Business Decisions 609

The Firm’s Risk Exposure from Foreign Operations 610
Accounting, or Translation, Exposure 610
Economic Exposure 610
Managing Currency Risk 612
The Foreign-Exchange Market 613
Hedging Contractual Exposure to Currency Risk 614
Hedging Long-Term Contractual Exposure to Currency Risk with
Swaps 620
Factors Affecting Changes in Exchange Rates 622
How Differences in Inflation Rates Affect Exchange Rates: The Purchasing
Power Parity Relation 623
The Relationship between Two Countries’ Inflation Rates and Interest
Rates: The International Fisher Effect 624
How Differences in Interest Rates Affect Exchange Rates: The Interest-Rate
Parity Relation 625
The Relation between Forward Rates and Future Spot Rates 626
Putting It All Together 627
Analyzing an International Investment Project 628
The Net Present Value Rule: A Brief Review 628
Surf and Zap Cross-Border Alternative Investment Projects 629
Contents xxi
Managing Country Risk 635

Invest in Projects with Unique Fveatures 635
Use Local Sourcing 635
Choose a Low-Risk Financial Strategy 636
Design a Remittance Strategy 636
Consider Buying Insurance Against Country Risk 636
Key Points 637
A p p e n d i x 1 7 . 1 Translating Financial Statements with the Monetary/

Nonmonetary Method and the All Current Method 639
The Monetary/Nonmonetary Method 639
The All Current Method 640
Which Method Is Better? 642
A p p e n d i x 1 7 . 2 The Parity Relations 643

The Law of One Price 643
The Purchasing Power Parity Relation 644
The International Fisher Effect 644
The Interest-Rate Parity Relation 645
Strategy 1: Investment in US Dollars 645
Strategy 2: Investment in Euros 646
Further Reading 647
chapter 1 8 Managing for Value Creation 653

Measuring Value Creation 654
Estimating Market Value Added 654
Interpreting Market Value Added 657
A Look at the Evidence 658
Identifying the Drivers of Value Creation 660
Linking Value Creation to Operating Profitability, the Cost of Capital,
and Growth Opportunities 661
Only Value-Creating Growth Matters 663
Linking Value Creation to Its Fundamental Determinants 664
Linking Operating Performance and Remuneration to Value
Creation 665
Mr. Thomas Hires a General Manager 666
Has the General Manager Achieved His Objectives? 667
Economic Profits Versus Accounting Profits 669
Designing Compensation Plans That Induce Managers to Behave Like
Owners 670
xxii Finance For Executives
Linking the Capital Budgeting Process to Value Creation 671

The Present Value of an Investment’s Future EVA Is Equal to Its MVA 672
Maximizing MVA Is the Same as Maximizing NPV 672
Putting It All Together: The Financial Strategy Matrix 675
The Business Is a Value Creator but Is Short of Cash 676
The Business Is a Value Creator with a Cash Surplus 676
The Business Is a Value Destroyer with a Cash Surplus 677
The Business Is a Value Destroyer That Is Short of Cash 677
Key Points 677
A p p e n d i x 1 8 . 1 Adjusting Book Values to Estimate the Amount of Invested Equity

Capital and Operating Profit 679
Adjusting the Book Value of Equity Capital 679
Adjusting Earnings Before Interest and Tax 680
A p p e n d i x 1 8 . 2 Estimating Market Value Added (MVA) when Future Cash Flows
are Expected to Grow at a Constant Rate in Perpetuity 682
Further Reading 683
Answers to Self-Test Questions 691

Glossary 741
Credits 763
Index 765
Preface
Finance is an essential and exciting area of management that many executives want
to learn or explore in more depth. Most finance textbooks, however, are either too
advanced or too simplistic for many nonfinancial managers. Our challenge was to
write an introductory text that is specifically addressed to executives, and that is
both practical and rigorous.
The target audience includes executives directly and indirectly involved with
financial matters and financial management, which is just about every executive.
Over the past few years, several thousand managers around the world have used
most of the material in this book. The text works well in executive-development
programs – including executive masters of business administration (EMBA)

programs – and corporate finance courses for an undergraduate or MBA audience
either as a core text, where a more practical and applied emphasis is desired, or as
a companion to a theoretical text to translate theory into practice.
Finance for Executives has a number of important features:
• The book is based on the principle that managers should manage their firm’s
resources with the objective of increasing their firm’s value.
Managers must make decisions that are expected to raise their firm’s market value.
This fundamental principle underlies our approach to management. This book is
designed to improve managers’ ability to make decisions that create value, including
decisions to restructure existing operations, launch new products, buy new assets,
acquire other companies, and finance the firm’s investments.
• The book fills the gap between introductory accounting and finance manuals for
nonfinancial managers and advanced texts in corporate finance.
Finance for Executives is based on modern finance principles. It emphasizes rigor-
ous analysis but avoids formulas that have no direct application to decision making.
Whenever a formula is used in the text, the logic behind it is explained and numeri-
cal examples are provided. Mathematical derivations of the formulas are given in
the appendices that follow the chapter in which they first appear. Recognizing that
executives often approach financial problems from a financial accounting perspec-
tive, we begin with a solid review of the financial accounting system. We then show
how this framework can be extended and used to make sound financial decisions
that enhance the firm’s value.
• The chapters are self-contained.
Each chapter can be read without prior reading of the others. When knowledge of a
previous chapter would enhance comprehension of a specific section, we direct the
xxiii
xxiv Finance For Executives
reader to that previously-developed material. Further advice on this score is pro-

vided in the section titled “How to Read This Book.”
• The book can be read in its entirety or used as a reference.
The book can be used as a quick reference whenever readers need to brush up on a
specific topic or close a gap in their financial management knowledge. A comprehen-
sive glossary and the index at the end of the book help the reader determine which
chapters deal with the desired issue or topic. Most financial terms are explained
when first introduced in the text; they appear in boldface type and are defined in the
glossary.
• Data from the same companies are used throughout the book to illustrate
diagnostic techniques and valuation methods.
We focus on the same set of firms to illustrate most of the topics covered in this
book. This approach provides a common thread that reinforces understanding.
• Spreadsheet solutions and formulas are included in the text.
Recognizing that spreadsheets have become part of most executives’ tool kit, the text
shows the spreadsheet solutions to all the examples, cases, and self-test questions,
when applicable. Formulas used in the spreadsheets are shown at the bottom of the
tables for an immediate understanding of the solutions and for reproduction of the
spreadsheets for personal use.
• Each chapter is followed by self-test and review questions.
The self-test questions that appear at the end of each chapter allow the readers to
assess their knowledge of the subject. Most of the questions require the use of a
financial calculator or a spreadsheet. Detailed, step-by-step solutions to the self-test
questions can be found at the end of the book.
The review questions, which follow the self-test questions at the end of each
chapter, provide the readers with the opportunity to challenge their knowledge of
the subject and give the instructors relevant material to test the student’s grasp of the
concepts and techniques presented in the chapter. Solutions to review questions are
available online only to instructors.
MAJOR CHANGES IN THE SIXTH EDITION

As was the case with the previous editions of Finance for Executives, we have
incorporated in the sixth edition recommendations received from our colleagues at
INSEAD and other schools and from a large number of students and executives who
have attended courses and seminars in which the book was assigned. Here are the
major changes from the last edition:
• We have written an entirely new chapter (Chapter 16) entitled Understand-
ing Forward, Futures, and Options and Their Contribution to Corporate
Finance.
• We have moved the presentation on currency risk from Chapter 15 (Managing
Corporate Risk) to Chapter 17 (Making International Business Decisions).
• We use a new set of international companies from the pharmaceutical industry,
GlaxoSmithKline and Sanofi, to illustrate how to perform a financial analysis
using the concepts and techniques presented in Chapters 4 through 6.
Preface xxv
• We have updated all chapters with the latest available financial information.
• We have introduced spreadsheets throughout the chapters to illustrate the
valuation of bonds, stocks, and companies.
• We have prepared a new set of professionally designed PowerPoint slides to
accompany the book.
WHAT IS IN THIS BOOK?

Although the book consists of self-contained chapters, those chapters follow a logical
sequence built around the idea of value creation. The overall structure of the book
is summarized in a diagram on the following page that illustrates the value-based
business model. Managers must raise cash (the right side) to finance investments (the
left side) that are expected to increase the firm’s value and the wealth of its owners.
Part I, Financial Concepts and Techniques, begins with a chapter that surveys the
principles and tools executives need to know to manage for value creation. Chapter
2 presents the concept of time value of money and reviews the mechanics of calculat-
ing present values for different streams of cash flows. Chapter 3 explains the rela-
tionship between the risk of a financial asset and its expected return, and examines
the implications for financial investment management and the valuation of financial
assets.
Part II, Assessing Business Performance, reviews the techniques that executives
should use to assess a firm’s financial health, evaluate and plan its future develop-
ment, and make decisions that enhance its chances of survival and success. The chap-
ters in this part examine in detail a number of financial diagnostics and managerial
tools that were introduced in Chapter 1. Chapter 4 explains and illustrates how
balance sheets, income statements, and statements of cash flows are constructed
and interpreted. As an application, the appendix includes the financial statements
of GlaxoSmithKline, an international pharmaceutical company. Chapter 5 shows
how to evaluate a firm’s operational efficiency and its liquidity position. Chapter 6
identifies the factors that drive a firm’s profitability, analyzes the extent of its expo-
sure to business and financial risks, and evaluates its capacity to finance its activi-
ties and achieve sustainable growth. The financial analysis tools presented in these
chapters are applied to GlaxoSmithKline, whose financial statements are presented
in Chapter 4. The analyses appear in the appendices to Chapters 5 and 6, including a
comparative analysis of GlaxoSmithKline and one of its major competitors, Sanofi.
Part III, Making Investment Decisions, demonstrates how managers should make
investment decisions that maximize the firm’s value. Chapter 7 examines the net
present value (NPV) rule in detail and shows how to apply this rule to make value-
creating investment decisions. Chapter 8 reviews a number of alternative approaches
to the NPV rule, including the internal rate of return (IRR) and the payback period
rules, and compares them with the NPV rule. Chapter 9 shows how to identify and
estimate the cash flows generated by an investment proposal and assess the pro-
posal’s capacity to create value.
Part IV, Making Financing Decisions, explains how managers should make financ-
ing decisions that maximize value. Chapter 10 shows how to value bonds and common
stocks. Chapter 11 explains how firms raise fresh capital from financial markets policy
and share buybacks. Chapter 12 shows how to estimate the cost of capital for a particu-
xxvi Finance For Executives
PART I: FINANCIAL CONCEPTS AND TECHNIQUES
How to convert a stream of future cash flows into

their present value.
What is the relationship between the risk of a

financial asset and its expected return, and what are
the implications for financial and investment management
and the valuation of financial assets?
PART II: ASSESSING BUSINESS

PERFORMANCE
How to interpret financial information to assess PART IV: MAKING

performance (Chapter 4), and how do financial FINANCING DECISIONS
structure and operational efficiency affect a firm's
liquidity (Chapter 5), profitability, risk, and capacity
to grow (Chapter 6)? How to value the
securities that firms
issue to raise funds?
PART Ill: MAKING
INVESTMENT DECISIONS How do firms raise the
funds needed to finance
their investments and return
cash to shareholders?
2
the funds the firm raises?

3
PART V: MAKING BUSINESS DECISIONS
How to use forward, futures and option contracts to control risk.

7
How do international activities affect the firm’s value?
8
Is the firm using its resources efficiently to create value?
Preface xxvii
lar project as well as an entire firm. Chapter 13 explains how a firm should make value-
creating financing decisions by designing a capital structure (the mix of owners’ funds
and borrowed funds) that maximizes its market value and minimizes its cost of capital.
Part V, Making Business Decisions, concludes with five chapters on making
value-creating business decisions. Chapter 14 reviews various models and tech-
niques used to value firms in the context of an acquisition. Chapter 15 provides a
comprehensive framework to identify, measure, and manage the risks a firm faces.
Chapter 16 shows how forward, futures, and option contracts can be used to control
risk. Chapter 17 looks at financial management and value creation in an interna-
tional environment where currency and country risks must be taken into account.
Chapter 18 summarizes the analytical framework underlying the process of value
creation and examines some of the related empirical evidence.
HOW TO USE THIS BOOK

Depending on your background and your needs, you may want to use this book in
different ways. Below are a few guidelines. Also, refer to the exhibit on the next page
for suggested sequences of chapters to cover depending on the type of program taken.
• If you are unfamiliar with financial management and financial accounting,
you may want to begin by reading Chapter 1. It provides an overview of
these subjects and will help you understand the fundamental objective of
modern corporate finance and the logical relationships among the various
issues and topics that make up that field. Although reading the first chapter
will facilitate the understanding of those that follow it, it is not necessary to
read it to comprehend the rest of the book – the chapters are self-contained.
• If you are not familiar with the basic concept of discounting and the calcula-
tion of present values, you should read Chapter 2. The chapter also shows
you how to perform present value calculations with a financial calculator
and spreadsheets. If you skip Chapter 2, you will find a review of these
concepts in Chapter 7.
• If you wish to familiarize yourself with the concept of portfolio diversifi-
cation and financial investment management you should read Chapter 3,
but you do not need to read that chapter to understand any of the other
chapters in the book.
• If you are not familiar with financial statements, it would be helpful, but
not essential, to read Chapter 4 before you continue with the chapters
in Part II. The chapter explains how to read a balance sheet, an income
statement, and a statement of cash flows, and how to restructure these
statements to interpret the information they provide.
• If you are unfamiliar with the functioning of financial markets, you should
read the first five sections of Chapter 11 before you continue with the rest
of Part IV. These sections provide an overview of the structure, organiza-
tion, and role of financial markets.
• Last, if you have a basic knowledge of accounting and finance, you can go
directly to the chapter dealing with the issue you wish to explore. Because
the chapters are self-contained, you will not have to review the preceding
chapters to fully understand your chosen chapter.
xxviii Finance For Executives
Recommended Chapters According to Type of Program

Executive Education MBA Program
Chapter/Topic
1st course 2nd course 1st course 2nd course
1. Overview ü ü
2. The time value of money ü ü
3. Risk, return, and portfolio analysis ü
4. Financial statements analysis ü ü
5. Operational efficiency and liquidity management ü ü
6. Profitability and risk management ü ü
7. Capital budgeting: NPV ü ü
8. Capital budgeting: IRR & other methods ü ü
9. Capital budgeting: Cash flow analysis ü ü
10. Bond valuation ü ü
10. Common stock valuation ü ü
11. Financial markets and raising capital ü ü
11. Dividend policy and share buybacks ü ü
12. Estimation of the cost of capital ü ü
13. Designing a capital structure ü ü
14. Valuing and acquiring a business ü ü
15. Corporate risk management ü ü
16. Forward, futures, and option contracts ü ü
17. International capital budgeting ü ü
18. Managing for value creation ü ü
About the authors
Gabriel Hawawini (Ph.D., New York University) is

emeritus professor of finance at INSEAD where he
served as dean and held the Henry Grunfeld Chair
in Investment Banking. He taught finance at New
York University, Baruch College, Columbia Univer-
sity, and the Wharton School of the University of
Pennsylvania where he received the Helen Kardon
Moss Anvil Award for Excellence in Teaching.
Professor Hawawini is the author of 12 books
and more than 70 research papers on financial
markets and corporate finance. He teaches value-
based management seminars around the world and
sits on the board of several companies.
Claude Viallet (Ph.D., Northwestern University)

was emeritus professor of finance at INSEAD. He
was visiting professor of finance at Kellogg School
of Management, Northwestern University. Before
joining INSEAD, he worked as a project manager
at a major oil company and as chief financial offi-
cer of a service company in Paris.
Professor Viallet was president of the European
Finance Association and published widely in lead-
ing academic and professional journals. He also
organized, directed, and taught management-
development programs in Europe, the United
States, Asia, and Latin America and provided con-
sulting services to companies around the world.
xxix
Acknowledgments
A number of colleagues and friends have been most generous with the time they
spent reading parts of the manuscript for the previous editions and providing spe-
cific comments and suggestions. We also have received many useful comments from
students and executives to whom the book was assigned.
We want to thank in particular our colleague Professor Pierre Michel who
reviewed the first draft of many chapters, and made numerous insightful comments.
We also want to thank Dr. Chittima Silberzahn for helping us update some of the
exhibits, and Mr. Bennett Stewart of ISS Corporate Solutions who kindly provided
us with the data in Chapter 18.
Below is the list of individuals who made comments and suggestions to some of
the chapters in the current and previous editions of the book. We thank them all for
their feedback.
José Benzinho (ISCAC Coimvria Business Sergei Glebkin (INSEAD)

School, Portugal) Adam Golinski, (University of York)
Tomasz S. Berent (Capital Markets Department, Dwight Grant (University of New Mexico)
Warsaw School of Economics, Poland) Denis Gromb (HEC Paris, France)
Hugh-Joel Bessis (HEC Paris, France) George Hachey (Bentley College)
Soren Bjerre-Nielsen (Chairman of MT Alfred Hawawini (Mirakl)
Hojgaard, Denmark) Pekka Hietala (INSEAD)
John Boquist (Indiana University) Pierre Hillion (INSEAD)
David Borst (Concordia University) A. Can Inci (Bryant University)
Jay T. Brandi (University of Louisville) Laurent Jacque (Tufts University)
Dave Brunn (Carthage College) Donald Keim (The Wharton School)
Adrian Buss (INSEAD) Paul Kleindorfer (deceased) (The Wharton
Bruno Chaintron (INSEAD) School)
David Champion (Harvard Business Review) Pascal Maenhout (INSEAD)
Sudip Datta (Wayne State University) Sophie Manigart (Vlerick Business School,
Jean Dermine (INSEAD) Belgium)
Helene Dore (Crédit Agricole-CIB) Kenneth J. Martin (New Mexico State University)
Stephen Doukas (Montreat College) Pedro Verga Matos (ISEG School of Econom-
Bernard Dumas (INSEAD) ics and Management, Technical University of
Theodoros Evgeniou (INSEAD) Lisbon, Portugal)
Paolo Fulghieri (University of North Carolina) Roger Mesznik (Columbia University)
Marco Garro (Bocconi University, Italy) Pierre Michel (University of Liège and the Free
Federico Gavazzoni (INSEAD) University of Brussels)
xxx
Acknowledgments xxxi
Arjen Mulder (Department of Finance, Rotter- K. P. Sridharan (Delta State University)

dam School of Management, Erasmus University, Sascha Steffen (European School of Management
The Netherlands) and Technology, Germany)
John Muth (Regis University) Aris Stouraitis (City University of Hong Kong)
Robert Obermaier (Faculty of Business Admin- John Strong (College of William & Mary)
istration and Economics, University of Passau, Matti Suominen (Aalto University School of
Germany) Economics)
Jerome Osreryoung (Florida State University) Lucie Tepla (INSEAD)
Joel Peress (INSEAD) Andy Terry (University of Arkansas at Little
Urs Peyer (INSEAD) Rock)
Art Raviv (Northwestern University) Nikhil P. Varaiya (San Diego State University)
Lee Remmers (INSEAD) Maria Vassalou (Columbia University)
Maryanne Rouse (University of South Florida) Theo Vermaelen (INSEAD)
Niels Sandalgaard (Department of Business and Ingo Walter (New York University)
Management, Aalborg University, Denmark) Clement Wong (University of Hong Kong)
José Miguel Pinto dos Santos (AESE Business David Young (INSEAD)
School) A. Burcin Yurtoglu (Corporate Finance,
Antonio Sanvicente (IBEC Sao Paulo) WHU – Otto Beisheim School of Management,
Ravi Shukla (Syracuse University) Germany)
Finally, we thank all the staff at Cengage Learning for their help
and support in all the phases of development and production.
Gabriel Hawawini
Claude Viallet
January 2019
xxxi
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be unstoppable
Financial Management
and Value Creation:
CHAPTER
1
An Overview
An executive cannot be an effective manager without a clear understanding of the

principles and practices of modern finance. The good news is that these principles
and practices can be communicated simply, without sacrificing thoroughness or
rigor. Indeed, you will discover that most of the concepts and methods underlying
modern corporate finance are based on business common sense. But translating busi-
ness common sense into an effective management system can be a real challenge.
It requires, in addition to a solid understanding of fundamental principles, the deter-
mination and the discipline to manage a business according to the precepts of modern
finance. Consider, for example, one of financial management’s most useful guiding
principles:
Managers should manage their firm’s resources with the objective of increasing the
firm’s value.
This may seem to be an obvious statement. But you probably know a number of
companies that are not managed to their full potential value. You may even know
well-intentioned managers who are value destroyers. Their misguided actions, or lack
of actions, actually reduce the value of their firms.
How do you manage for value creation? This book should help you find the
answer. Our main objective is to present and explain the methods and tools that will
help you determine whether the firm’s current investments are creating value and, if
they are not, what remedial actions should be taken to improve operations. We also
show you how to determine whether a business proposal – such as the decision to
buy a piece of equipment, launch a new product, acquire another firm, or restruc-
ture existing operations – has the potential to raise the firm’s value. Finally, we show
you that managing with the goal of raising the firm’s value provides the basis for
an integrated financial management system that helps you not only evaluate actual
business performance and make sound business decisions, but also design effective
management compensation packages – compensation packages that align the interests
of the firm’s managers with those of the firm’s owners.
This introductory chapter reviews some of the most challenging issues and ques-
tions raised by modern corporate finance and gives a general but comprehensive
1
2 Finance For Executives
overview. Although the topics surveyed here are examined later in detail, many of
the important terms and concepts are introduced and defined in this introduction
with a clear indication of the relevant chapters you need to consult to get a complete
presentation of each topic. After reading this chapter, you should have a broad and
clear understanding of the following:
• The meaning of managing a business for value creation
• How to measure the value that may be created by a business proposal, such
as an investment project, a change in the firm’s financial structure, a business
acquisition, or the decision to invest in a foreign country
• The significance of the firm’s cost of capital and how it is measured
• Why some firms pay out cash dividends to their shareholders and buy back
their own shares in the open market
• The function of financial markets as a source of corporate funds and the role
they play in the value-creation process
• A firm’s business cycle and how it determines the firm’s capacity to grow
• The basic structure and the logic behind a firm’s balance sheet, income state-
ment, and cash-flow statement
• What is risk and how to define it, and how it affects the firm’s cost of capital
• How to measure a firm’s profitability
• How to determine if a firm is creating value
THE KEY QUESTION: WILL YOUR DECISION CREATE VALUE?

Suppose you have identified a need in the marketplace for a new product. You believe
the product can be manufactured cheaply and rapidly. You are even confident it can
be sold for a tidy profit. Should you go ahead? Before you make this decision, you
should check the project’s long-term financial viability. How will your firm finance
the project? Where will the money come from? Will the project be sufficiently profit-
able to cover the cost of the funds required to finance it? More to the point, will the
firm be more valuable with the project than without it? You should answer these
questions before making a final decision.
The proposed venture will be financed by the firm’s owners, its shareholders
(you may be one of them), and by those who lend money to the firm, the debt holders
(a bank, for example). Cash contributed by shareholders is called equity capital;
cash contributed by lenders is debt capital. As with any other resource, capital is not
free. It has a cost. Let’s assume that the firm’s annual cost of capital is 12 percent
of the total amount of capital employed, the sum of equity and debt capital. The
firm’s owners will find the venture attractive only if its operating profitability exceeds
12 percent, that is, only if its profitability before financing the venture is higher than the
cost of capital of 12 percent. Why? Because a project whose operating profitability
exceeds its cost of capital should generate more cash than is required to pay for the
cost of capital. It is that excess cash that makes the firm more valuable. (We will
explain this in more detail throughout the book.) In other words, before deciding to
go ahead with a business proposal, you should ask yourself the Key Question:
Will the proposal create value?
If, in light of existing information and proper analysis, you can confidently answer
“yes”, then go ahead with the project. Otherwise, you should abandon it.
Chapter 1 Financial Management and Value Creation: An Overview 3
The Key Question applies not only to a business proposal but also to current
operations. If some existing assets are destroying rather than creating value, you
should take immediate corrective actions. If these actions fail to improve perfor-
mance, you should seriously consider selling those assets.
The Importance of Managing for Value Creation

We realize, of course, that the Key Question is much easier asked than answered. The
next section describes how to apply the fundamental finance principle to help you
answer the Key Question. Before introducing that principle, we want to explain why
management’s paramount objective should be the creation of value for the firm’s
owners. This objective makes business common sense if you think about a firm whose
recent management decisions reduced the firm’s value. What would happen in this
case? The firm may be unable to attract the equity capital it needs to fund its activi-
ties. And without equity capital, no firm can survive.
You may rightly ask whether we are forgetting the contributions of employees,
customers and suppliers. No firm can succeed without them. Great companies have
not only satisfied owners, but also loyal customers, motivated employees, and reli-
able suppliers. The point, of course, is not to neglect customers, squeeze suppliers,
or ignore the interest of employees for the benefit of owners: more value for share-
holders does not mean less value for employees, customers, or suppliers. On the con-
trary, firms managed with a focus on creating value for their owners are among those
that have built durable and valuable relationships with their customers, employees,
and suppliers. They know that dealing successfully with employees, customers, and
suppliers is an important element in achieving their ultimate objective of creating
value for their owners.
Indeed, evidence supports the fact that firms that take care of their customers and
employees also deliver value to their owners. Consider the results of an annual survey
that asked executives, outside directors, and financial analysts to rate the ten largest
companies in their industry according to the following criteria: (1) quality of manage-
ment; (2) quality of products or services; (3) ability to attract, develop, and keep tal-
ented people; (4) company’s value as a long-term investment; (5) use of corporate assets;
(6) financial soundness; (7) capacity to innovate; and (8) community and environmental
responsibilities.1 The companies with the highest scores across all industries signifi-
cantly outperformed the Standard & Poor’s market index (an average of 500 c ompanies)
during the ten-year period that preceded the ranking. What was the stock market
performance of the companies with the lowest scores? They were value destroyers. They
delivered a negative return to their shareholders during the ten-year period that
preceded the ranking. An analysis based on only the three criteria that relate to the way
companies treat their customers (the second criterion), their employees (the third
criterion), and their community (the last criterion) showed similar results.2
These results clearly indicate that the ability of firms to create value for their
shareholders is related to the way they treat their customers, employees, and com-
munity. But you should not conclude that the guaranteed recipe for value creation
consists of delighting customers, establishing durable relations with suppliers, and
motivating employees. Some firms that deal successfully with their customers,
employees, and suppliers are unable to translate this goodwill into a higher firm value.
1
See fortune.com/worlds-most-admired-companies.
2
See Edmans (2011) and (2012). For international evidence, see Edmans, Li, and Zhang (2014).
What should the firm’s managers do in this case? They must revise the firm’s current
business strategy because their shareholders will eventually question the relevance of
a strategy that does not allow the firm to produce a satisfactory return on the equity
capital they have invested in it. Dissatisfied shareholders, particularly those holding
a significant portion of the firm’s equity capital, may try to force the firm’s manage-
ment to change course or may try to oust the existing management team. Or, they
may simply withdraw their support by selling their holdings to others who might
force changes.
Whether shareholders will be successful in getting management to change its
strategy, or even be replaced, depends on a number of factors, including the institu-
tional and legal frameworks that govern the relationship between management and
shareholders, and the structure and organization of the country’s equity markets in
which the firm’s shares are listed and traded. We simply suggest that no firm can
afford to have delighted customers, motivated employees, and devoted suppliers for
too long if it does not also have satisfied shareholders.
When asked in whose interest corporations are run, Mr. Jack Welch, the former
chief executive officer of General Electric, replied, “A proper balance between share-
holders, employees, and communities is what we all try to achieve. But it is a tough
balancing act because, in the end, if you don’t satisfy shareholders, you don’t have
the flexibility to do the things you have to do to take care of employees or communi-
ties. In our society, whether we like it or not, we have to satisfy shareholders.”3
The Saturn Story

In the early 1980s, General Motors (GM), then the world’s largest vehicle manufac-
turer, faced strong competition from foreign producers of small, efficient, reliable,
and inexpensive cars. In response to this challenge, in 1985, GM set up a separate
company to build an entirely new car, the Saturn. The car was designed, produced,
and sold according to the best practices available at the time. Workers were highly
motivated, car dealers could not keep up with demand, and customers were extremely
satisfied with their cars. According to these criteria, Saturn was an undeniable suc-
cess story.
The first car rolled off the assembly line in 1990. The project, however, never
delivered the rise in the value of GM’s shares that management had hoped would
occur.4 Why?
According to knowledgeable consultants, the $6 billion spent developing, manu-
facturing, and marketing the Saturn line of models was already so high that for GM
to earn an acceptable return for its shareholders it would have had “to operate
existing facilities at full capacity forever, earn more than double standard profit mar-
gins, and keep 40 percent of the dealers’ sticker price as net cash flow.”5
In 2009 GM stopped producing its line of Saturn cars, and in 2010 it discon-
tinued the Saturn brand after acknowledging that it had lost about $20 billion on the
project.6
3
Fortune, May 29, 1995, p. 75.
4
Fortune, December 13, 2004, “GM’s Saturn Problem,” pp. 119–127.
5
McTaggart, Kontes, and Mankins (1994), p. 16.
6
See the New York Times, October 1, 2009, “GM to Close Saturn After Deal Fails,” and “Saturn Corpora-
tion” in Wikipedia.org.
Our question is: how long should a firm fund a project that delights its customers,
pleases its distributors, and satisfies its employees, but fails to deliver value to its
shareholders? Obviously, not very long if it wishes to survive. So what can we con-
clude about the ultimate purpose of a business enterprise? Is it exclusively about
shareholder wealth creation, or is it about a “stakeholders’ approach” that tries to
balance the interests of all the parties associated with the firm (its customers,
employees, suppliers, and owners)? We believe that this is a false debate. The focus
should be on making decisions that raise the value of the firm, and in doing so, the
firm ultimately creates value for its stakeholders and society as a whole.7
THE FUNDAMENTAL FINANCE PRINCIPLE

Recall the Key Question you should ask before making a business decision: will the
decision create value? The Key Question can be answered with the help of the fun-
damental finance principle:
A business proposal – such as a new investment, the acquisition of another company,
or a restructuring plan – will create value only if the present value of the future
stream of net cash benefits the proposal is expected to generate exceeds the initial
cash outlay required to carry out the proposal.
The present value of the future stream of expected net cash benefits is the amount
of dollars that makes the firm’s owners indifferent to whether they receive that sum
today or get the expected future cash-flow stream. For example, if the firm’s owners
are indifferent to whether they receive a cash dividend of $100,000 today or get an
expected cash dividend of $110,000 next year, then $100,000 is the present value
of $110,000 expected next year. (See Chapter 2 for a review of how present values
are calculated.)
Measuring Value Creation with Net Present Value

The difference between a proposal’s present value and the initial cash outlay required
to implement the proposal is the proposal’s net present value or NPV:
Net present value 5 2Initial cash outlay 1 Present value of future net cash benefits
For example, if a firm’s owners are indifferent between $100,000 today and $110,000
in one year, then a project that requires $105,000 today to buy a machine that is
expected to generate a net cash flow of $110,000 next year, has a negative NPV of
$5,000 because next year’s cash flow is worth $100,000 today, which is $5,000 less
than the initial cash outlay:
NPV 5 2$105,000 1 $100,000 5 2$5,000
If the project is undertaken, it would reduce the value of the firm by $5,000.
We can use the NPV concept to restate the fundamental finance principle more
succinctly:
A business proposal creates value if its NPV is positive and destroys value if its NPV
is negative.
7
For a discussion on whether creating value for owners also creates value for all the firm’s stakeholders,
see John Martin, William Petty, and James Wallace (2009).
The proposal’s NPV goes to the investors who own the project – in other words, to
the shareholders of the firm that undertakes the project. This means that the share-
holders should be able to sell their equity stake in the company that announced the
project for more than they could sell it for if the project were not undertaken, and
the difference should be equal to the project’s NPV.
The firm’s ability to identify the project, and the market expectation that the
firm will carry out the project successfully, create an immediate increase in the firm’s
value and in the wealth of its owners. More precisely, if the shares of the firm are
listed and traded on a stock exchange, the market value of the firm (the share price
multiplied by the number of shares outstanding) should rise by an amount equal to
the project’s NPV on the day the project is announced, assuming the announcement
is unanticipated, and the market agrees with the firm’s analysis of the project’s profit-
ability. We return to this point later in the chapter when we examine the role played
by financial markets in the process of value creation.
Only Cash Matters

The fundamental finance principle requires that the initial investment needed to
undertake a proposal, as well as the stream of net future benefits it is expected
to generate, be measured in cash. As Exhibit 1.1 shows, the investors who are
financing the proposal – the firm’s shareholders and debt holders – have invested
cash in the firm and thus are interested only in cash returns. Note that the cash
benefits of a project must not be confused with the increase in the firm’s net profit
expected from the project because profits are accounting measures of benefits, not
of cash returns.
Chapter 4 identifies the differences between a firm’s cash flows, its revenues, its
expenses, and its net profit, and Chapter 9 shows how to estimate the cash flows that
are relevant to an investment decision.
Discount Rates
Consider an investment proposal that requires shareholders to invest $100,000 today
in order to generate an expected $110,000 of cash at the end of the year. Suppose
that the present value of the $110,000 is $100,000. Recall that the present value is
the value that makes the firm’s owners indifferent to whether they receive $100,000
Exhibit 1.1 Only Cash M atters to Investors.
today or receive the expected $110,000 in one year. This is the same as saying that
the firm’s owners expect to receive a return of 10 percent from the project because
$100,000 invested at 10 percent will yield $110,000 in one year. The 10 percent is
called the discount rate: it is the rate at which the future cash flow must be dis-
counted to find its present value. In other words, $100,000 is the discounted value
at 10 percent of $110,000 to be received in one year.
If we want to estimate the NPV of a proposal, we must first discount its future
cash-flow stream to find its present value and then deduct from that present value
the initial cash outlay required to carry out the proposal. Chapter 2 examines the
discounting mechanism in detail and explains how to calculate present values and
how to estimate a project’s NPV when the project has an expected cash-flow stream
that is longer than one year.
In our example, we know the discount rate (10 percent) because we already know
the expected future cash flow ($110,000) and its present value ($100,000). However,
this is not usually the case. In general, a proposal’s future cash flow must be estimated,
and the discount rate must be determined. But what discount rate should be used?
A proposal’s appropriate discount rate is the cost of financing the proposal.
In the example, the return expected from the project must be at least 10 percent
to induce shareholders to invest in the project. In other words, because 10 percent is
the rate of return required by shareholders to fund the project, it is also the project’s
cost of equity capital. It represents the cost of using shareholders’ cash to finance
the investment proposal.
A Proposal’s Cost of Capital

In the previous example, the project was funded only with equity capital. Firms,
however, typically finance their investment proposals with a combination of equity
capital and debt capital, and both shareholders and debt holders require a return
from their contribution to the financing of the proposal. When a project is funded
with both equity and debt capital, the cost of capital is no longer equal to just the
cost of equity. It is the weighted average of the project’s cost of equity and its after-
tax cost of debt,8 where the weights are the proportions of equity and debt financing
in the total capital used to fund the project.
To illustrate, suppose a project will be financed 50 percent with equity and
50 percent with debt. Also, assume the project has an estimated after-tax cost of
debt of 4 percent and a cost of equity of 12 percent. Then, the project’s weighted
average cost of capital or WACC is equal to 8 percent:
Project cost of capital 1 WACC 2 5 1 4% 3 50% 2 1 1 12% 3 50% 2

5 2% 1 6%
5 8%
In other words, the contribution of debt financing to the project’s cost of capital
is 2 percent (50 percent of 4 percent) and that of equity financing is 6 percent
(50 percent of 12 percent) as shown in Exhibit 1.2.
If the proportions of equity and debt financing are modified, the WACC will be
affected, not only because the financing proportions have changed but also because
the cost of debt and the cost of equity change when the financing proportions are
8
We explain in Chapter 12 why the cost of debt must be taken after tax.
The Cost of Financing a Business Proposal is its Weighted Average

Exhibit 1.2
Cost of Capital.
altered. Chapter 12 shows how to estimate a project’s cost of debt as well as its cost
of equity and WACC. Chapter 13 demonstrates how the WACC is affected when the
financing proportions change.
APPLYING THE FUNDAMENTAL FINANCE PRINCIPLE

The fundamental finance principle has widespread applications in major areas of corpo-
rate decision-making. In this book, we address the capital budgeting decision (whether
an investment project should be accepted or rejected), the payout policy (when and how
much cash the firm should distribute to its shareholders through cash dividends and/or
by buying back its own shares in the open market), the capital structure decision (how
much of the firm’s assets should be financed with equity and how much with debt), the
business acquisition decision (how much should be paid to acquire another company),
and the foreign investment decision (how to account for multiple-currency cash flows
and for the different risks of operating in a foreign country). The capital budgeting
decision is covered in Chapters 7 through 9, the payout policy in Chapter 11, the
capital structure decision in Chapter 13, the acquisition decision in Chapter 14, and
the management of cross-border operations in Chapter 17. This section provides an
overview of these corporate decisions.
The Capital Budgeting Decision

The capital budgeting decision, also called the capital expenditure decision, is
primarily concerned with the acquisition of fixed assets, such as plant and equipment.
This is a major corporate decision because it typically affects the firm’s business per-
formance for a long period of time. The decision criteria used in capital budgeting,
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Fig. 174.—Development of wings in Caloptenus spretus: the upper row
gives a lateral view of the thoracic segments, and the lower row a
dorsal view of these segments; 1, second instar; 2, third instar; 3,
fourth instar; 4, fifth instar. (After Riley.) t, tegmen; w, wing.
Fig. 175.—Caloptenus spretus. North America. A, Newly hatched,

much magnified; B, adult, natural size. (After Riley.)
Riley and Packard have given an account[221] of some parts of the

post-embryonic development of the Rocky Mountain Locust, which
enables us to form a satisfactory conception of the stages of
development of the wings. Fig. 175, A, represents the first instar, the
young locust, just emerged from the egg and colourless. Fig. 174
shows some of the subsequent stages of development of the wings,
the upper line of figures giving a profile view of the thoracic
segments, and the lower line showing their dorsal aspects; 1 shows
the condition of the parts in the second instar, the chief difference
from the first instar being the development of colour; in the third
instar there is an evident slight development of the future alar
organs, exhibited chiefly in the outgrowth and lobing of the free
posterior angles of the meso- and metanota, as shown in Fig. 174, 2.
After the third moult there is a great difference; the instar then
disclosed—the fourth—has undergone a considerable change in the
position of the meso- and metathoraces, which are thrust forward
under the pronotum; this has become more enlarged and hood-like
(Fig. 174, 3); at the same time the wing-rudiments have become free
and detached, the metathoracic pair being the larger, and
overlapping the other pair. The fifth instar (Fig. 174, 4) differs but
little from the fourth, except in the larger size of the pronotum and
wing-rudiments. The sixth—shown in Fig. 175, B—is the perfect
Insect, with the alar organs free and large, the prothorax much
changed in form, the colour different. From the above it will be seen
that the chief changes occurred at the third and fifth ecdyses, after
each of which a considerable difference in the form of the Insect was
revealed. In the first three instars the sexes can scarcely be
distinguished, in the fourth they are quite distinct, and in the fifth
coupling is possible, though usually it does not occur till the final
stage is attained.
The discovery that Orthoptera change their colours in the course of

their development, and even after they have become adult, is
important, not only from a physiological point of view, but because it
throws some light on the questions as to the number of species and
the geographical distribution of the migratory locusts, as to which
there has existed a great confusion.
The Acridiidae are considered to be exclusively vegetable feeders,

each individual consuming a very large quantity of food. The mode in
which the female deposits her eggs has been described by Riley,
[222] and is now widely known, his figures having been frequently
reproduced. The female has no elongate ovipositor, but possesses
instead some hard gonapophyses suitable for digging purposes; with
these she excavates a hole in the ground, and then deposits the
eggs, together with a quantity of fluid, in the hole. She prefers hard
and compact soil to that which is loose, and when the operation is
completed but little trace is left of it. The fluid deposited with the eggs
hardens and forms a protection to them, corresponding to the more
definite capsules of the cursorial Orthoptera.
The details of the process of oviposition and of the escape of the

young from their imprisonment are of much interest. According to
Künckel d'Herculais[223] the young Stauronotus maroccanus
escapes from the capsule by putting into action an ampulla formed
by the membrane between the head and the thorax; this ampulla is
supposed to be dilated by fluid from the body cavity, and is
maintained in the swollen condition by the Insect accumulating air in
the crop beneath it. In order to dislodge the lid of the capsule, six or
seven of the young ones inside combine their efforts to push it off by
means of their ampullae. The ampulla subsequently serves as a sort
of reservoir, by the aid of which the Insect can diminish other parts of
the body, and after emergence from the capsule, penetrate cracks in
the earth so as to reach the surface. Immediately after doing this the
young Stauronotus moults, the skin it casts being called by Künckel
an amnios. The cervical ampulla reappears at subsequent moults,
and enables the Insect to burst its skin and emerge from it.
The process is apparently different in Caloptenus spretus, which,

according to Riley, ruptures the egg-shell and works its way out by
the action of the spines at the apex of the tibiae. This latter Insect
when it emerges moults a pellicle, which Riley considers to be part of
the embryonic membranes.
Riley states that a female of Caloptenus spretus makes several egg-

masses. Its period of ovipositing extends over about 62 days, the
number of egg-masses being four and the total number of eggs
deposited about 100. The French naturalists have recently observed
a similar fact in Algeria, and have ascertained that one of the
migratory locusts—Schistocerca peregrina—may make a deposit of
eggs at more than one of the places it may alight on during its
migration.
It has been ascertained that the eggs of Acridiidae are very nutritious
and afford sustenance to a number of Insects, some of which indeed
appear to find in them their sole means of subsistence. Beetles of
the family Cantharidae frequent the localities where the eggs are laid
and deposit their eggs in the egg-masses of the Orthoptera, which
may thus be entirely devoured. Two-winged flies of the family
Bombyliidae also avail themselves of these eggs for food, and a mite
is said to be very destructive to them in North America. Besides
being thus destroyed in enormous quantities by Insects, they are
eaten by various birds and by some mammals.
Most of the Insects called locusts in popular language are members

of the family Acridiidae, of which there are in different parts of the
world very many species, probably 2000 being already known. To
only a few of these can the term Locust be correctly applied. A locust
is a species of grasshopper that occasionally increases greatly in
number, and that moves about in swarms to seek fresh food. There
are many Orthoptera that occasionally greatly increase in numbers,
and that then extend their usual area more or less; and some
Acridiidae multiply locally to a great extent—very often for one or two
seasons only,—and are then called locusts. The true migratory
locusts are species that have gregarious habits strongly developed,
and that move over considerable distances in swarms. Of these
there are but few species, although we hear of their swarms in many
parts of the world.
The migratory locusts do much more damage than the endemic

species. In countries that are liable to their visitations they have a
great influence on the prosperity of the inhabitants, for they appear
suddenly on a spot in huge swarms, which, in the space of a few
hours, clear off all the vegetable food that can be eaten, leaving no
green thing for beast or man. It is difficult for those who have not
witnessed a serious invasion to realise the magnitude of the event.
Large swarms consist of an almost incalculable number of
individuals. A writer in Nature[224] states that a flight of locusts that
passed over the Red Sea in November 1889 was 2000 square miles
in extent, and he estimated its weight at 42,850 millions of tons, each
locust weighing 1⁄16 of an ounce. A second similar, perhaps even
larger, flight was seen passing in the same direction the next day.
That such an estimate may be no exaggeration is rendered probable
by other testimony. From official accounts of locusts in Cyprus we
find that in 1881,[225] up to the end of October, 1,600,000,000 egg-
cases had been that season collected and destroyed, each case
containing a considerable number of eggs. By the end of the season
the weight of the eggs collected and made away with amounted to
over 1300 tons, and, notwithstanding this, no less than
5,076,000,000 egg-cases were, it is believed, deposited in the island
in 1883.
When we realise the enormous number of individuals of which a

large swarm of locusts may consist we can see that famine is only a
too probable sequence, and that pestilence may follow—as it often
has done—from the decomposition of the bodies of the dead Insects.
This latter result is said to have occurred on some occasions from
locusts flying in a mass into the sea, and their dead bodies being
afterwards washed ashore.
Locust swarms do not visit the districts that are subject to their
invasions every year, but, as a rule, only after intervals of a
considerable number of years. It has been satisfactorily ascertained
that in both Algeria and North America large swarms occur usually
only at considerable intervals. In North America Riley thought[226]
the average period was about eleven years. In Algeria the first
invasion that occurred after the occupation of the country by the
French was in 1845, the second in 1864, the third in 1866, since
which 1874 and 1891 have been years of invasion. These breaks
seem at first strange, for it would be supposed that as locusts have
great powers of increase, when once they were established in any
spot in large numbers, there would be a constant production of
superfluous individuals which would have to migrate as regularly as
is the case with swarms of bees. The irregularity seems to depend
on three facts: viz. that the increase of locusts is kept in check by
parasitic Insects; that the eggs may remain more than one year in
the ground and yet hatch out when a favourable season occurs; and
that the migratory instinct is only effective when great numbers of
superfluous individuals are produced.
It is not known that the parasites have any power of remaining in

abeyance as the locust eggs may do; and the bird destroyers of the
locusts may greatly diminish in numbers during a year when the
Insects are not numerous; so that a disproportion of numbers
between the locusts and their destroyers may arise, and for a time
the locusts may increase rapidly, while the parasites are much
inferior to them in numbers. If there should come a year when very
few of the locusts hatch, then the next year there will be very few
parasites, and if there should then be a large hatching of locusts
from eggs that have remained in abeyance, the parasites will not be
present in sufficient quantity to keep the destructive Insects in check;
consequently the next year the increase in number of the locusts
may be so great as to give rise to a swarm.
It is well established that locusts of the migratory species exist in

countries without giving rise to swarms, or causing any serious
injuries; thus Pachytylus cinerascens—perhaps the most important
of the migratory locusts—is always present in various localities in
Belgium, and does not give rise to swarms. When migration of
locusts does occur it is attended by remarkable manifestations of
instinct. Although several generations may elapse without a
migration, it is believed that the locusts when they migrate do so in
the direction taken by predecessors. Their movements are to a large
extent dependent on the wind, and it is said that they make trial
flights to ascertain its direction. When on the wing probably very little
muscular effort is necessary. Their bodies contain elastic air sacs in
communication with the tracheae, and at the time of flight it may be
presumed that the body is comparatively empty, food being wanting,
and the internal organs of reproduction, which occupy a large space
when in activity, yet undeveloped, hence the sacs have full room for
expansion, as explained on p. 283. Thus the Insects exert but little
effort in their aerial movements, and are, it is believed, chiefly borne
by the wind. Should this become unfavourable it is said that they
alight and wait for a change.
The most obscure point in the natural history of the migratory locusts
appears to be their disappearance from a spot they have invaded. A
swarm will alight on a locality, deposit there a number of eggs, and
then move on. But after a lapse of a season or two there will be few
or none of the species present in the spot invaded. This appears to
be partly due to the young locusts dying for want of food after
hatching; but in other cases they again migrate after growth to the
land of their ancestors. The latter fact is most remarkable, but it has
been ascertained by the U.S. Entomological Commission that these
return swarms do occur.
Fig. 176.—Portions of body of Caloptenus spretus to show some of the

air-sacs. (Modified from Packard.) A, Dorsal aspect of anterior
parts; B, lateral aspect of posterior parts of body; a, enlargements
of tracheae in head; b, pair of large sacs in thorax; c, sacs on the
tracheal trunks of abdomen; s, spiracles.
In South Africa it would appear that the movements of the migratory

locusts are frequently made before the Insects have acquired their
wings. Mrs. Barber, in an account of "Locusts and Locust-Birds in
South Africa,"[227] has illustrated many points in the Natural History
of these Insects. The South African species manifests the gregarious
and migratory disposition when the individuals are quite young, so
that they travel in flocks on foot, and are called by the Dutch
"Voetgangers." After hatching, the various families of young
amalgamate, so that enormous numbers come together. Having
denuded the neighbourhood of all its food-supplies, they move off in
search of fresh crops and pastures new. They take advantage of
roads, and sometimes a good many miles will be traversed in a day;
they proceed by means of short leaps, rapidly repeated. When the
"Voetgangers" are thus returning northwards towards the lands in the
interior from which their progenitors departed, no obstacles can stay
their course. Forests or rivers may intervene, diverting them for a
while from their line of march, but they succeed ultimately in
continuing their journey to the interior.
The manner in which these wingless locusts occasionally cross

broad rivers is interesting, as it has some bearing on the difficult
question of the possibility of winged locusts crossing seas of
considerable width. Mrs. Barber refers to an instance that took place
on the Vaal River in the spring of the year 1871, shortly after the
discovery of the Diamond-fields. The country was at that time
swarming with young locusts; every blade of grass was cleared off
by them. One day a vast swarm of the "Voetgangers" made their
appearance on the banks of the Vaal River; they appeared to be in
search of a spot for crossing, which they could not find, the river
being somewhat swollen. For several days the locusts travelled up
the stream; in the course of doing this they paused for some time at
an abrupt bend in the river where a number of rocks were cropping
out, as if in doubt whether to attempt a passage at this place. They,
however, passed on, as if with the hope of finding a better ford; in
this apparently they were disappointed, for three days afterwards
they returned to the same bend of the river, and there plunged in
vast multitudes into the stream, where, assisted by a favourable
current and the sedges and water-plants which grew upon the
projecting rocks, they managed to effect a crossing, though great
numbers were drowned and carried away by the flooded river. Mrs.
Barber adds that "Voetgangers" have been known to attempt the
passage of the Orange River when it was several hundred yards in
breadth, pouring their vast swarms into the flooded stream
regardless of the consequences, until they became heaped upon
each other in large bodies. As the living mass in the water
accumulated, some portions of it were swept away by the strong
current from the bank to which they were clinging, and as the living
locusts tightly grasped each other and held together, they became
floating islands, the individuals continually hopping and creeping
over each other as they drifted away. Whether any of the locust-
islands succeeded in reaching the opposite bank is unknown;
probably some of them were drifted on land again. They are by no
means rapid swimmers; they do not perish easily in the water when
in masses, their habit of continually changing places and hopping
and creeping round and round upon each other being very
advantageous as a means of preservation. It is a common practice
for the young locusts to form a bridge over a moderately broad
stream by plunging indiscriminately into it and holding on to each
other, grappling like drowning men at sticks or straws, or, in fact,
anything that comes within their reach, and that will assist in floating
them; meanwhile those from behind are eagerly pushing forward
over the bodies of those that are already in the stream and hurrying
on to the front, until at length by this process they reach the opposite
bank of the river; thus a floating mass of living locusts is stretched
across the stream, forming a bridge over which the whole swarm
passes. In this manner few, comparatively speaking, are drowned,
because the same individuals do not remain in the water during the
whole of the time occupied by the swarm in crossing, the Insects
continually changing places with each other; those that are beneath
are endeavouring to reach the surface by climbing over others, whilst
those above them are, in their turn, being forced below. Locusts are
exceedingly tenacious of life, remaining under water for a
considerable time without injury. An apparently drowned locust will
revive beneath the warm rays of the sun, if by chance it reaches the
bank or is cast on shore. Mrs. Barber relates an interesting case
where the instinct of the "Voetgangers" was at fault, they plunging
into a river from a steep sandy bank, only to find another similar
sandy precipice on the other side. On this they could gain no footing,
and all perished in the stream, where they putrefied, and caused the
death of the fish, which floated likewise on the surface; so powerful
were the effluvia produced that no one was able to approach the
river.
Locusts are able to travel considerable distances, though how far is
quite uncertain. Accounts vary as to their moving by night. It has,
however, been recently proved that they do travel at night, but it is
not ascertained how long they can remain in the air without
descending. The ocean is undoubtedly a source of destruction to
many swarms; nevertheless, they traverse seas of considerable
width. They have been known to reach the Balearic Islands, and
Scudder gives[228] a well-authenticated case of the occurrence of a
swarm at sea. On the 2nd of November 1865 a ship on the voyage
from Bordeaux to Boston, when 1200 miles from the nearest land,
was invaded by a swarm of locusts, the air and the sails of the ship
being filled with them for two days. The species proved to be
Acridium (Schistocerca) peregrinum. This is an extraordinary case,
for locusts do not fly with rapidity, being, indeed, as we have
remarked, chiefly carried by the wind. Possibly some species may
occasionally rest on the water at night, proceeding somewhat after
the fashion of the "Voetgangers" when passing over rivers as
described by Mrs. Barber. In Sir Hans Sloane's history of Jamaica an
account of an occurrence of this kind is given on the authority of
Colonel Needham, who states that in 1649 locusts devastated the
island of Tenerife, that they were seen to come from Africa when the
wind was blowing thence, that they flew as far as they could, then
alighted on the water, one on the other, till they made a heap as big
as the greatest ship, and that the next day, being refreshed by the
sun, they took flight again and landed in clouds at Tenerife. De
Saussure says[229] that the great oceans are, as a rule, impassable
barriers, and that not a species of the tribe Oedipodides has passed
from the Old World to the New. It is, however, possible that Acridium
peregrinum, of the tribe Acridiides, may have originally been an
inhabitant of America, and have passed from thence to the Old
World.
Fig. 177.—European migratory locust, Pachytylus cinerascens ♀.
The species of Acridiidae that have been ascertained to be migratory

are not numerous.[230] The most abundant and widely distributed of
them is Pachytylus cinerascens (Fig. 177), which has invaded a
large part of the Eastern hemisphere, extending from the Atlantic
Ocean to China. It exists in numerous spots in the Oriental region
and the Asiatic Archipelago, and even in New Zealand. It is the
commoner of the locusts of Europe. Its congener, P. migratorius, is
much less widely distributed, its migrations being, according to de
Saussure, limited to Turkestan and Eastern Europe. A third species,
P. migratorioides, inhabits Eastern Africa, and a variety of it is the
"Yolala" or locust of Madagascar. Mr. Distant has informed the writer
that this migratory locust is found in South Africa. P. (Oedaleus)
marmoratus has almost as wide a distribution in the Eastern
hemisphere as P. cinerascens, except that it is more exclusively
tropical; it is thus excluded from New Zealand. P. (Oedaleus)
nigrofasciatus has a more northern distribution than its congener, but
has extended to Africa and the Asiatic Archipelago. This Insect is so
variable that the distinctions of its races from other species of the
same genus are not yet clear. All the above-mentioned locusts
belong to the tribe Oedipodides. Acridium peregrinum, now more
frequently called Schistocerca peregrina, belongs to the tribe
Acridiides. It is a large locust (Fig. 84), and has a wide distribution. It
is the chief species in North Africa, and is probably the locust of the
plagues of Egypt mentioned in the book of Exodus. It is also,
according to Cotes,[231] the chief locust of North-West India. In this
latter country Pachytylus cinerascens and some other species also
occur. With the exception of S. peregrina, the species of the genus
Schistocerca are confined to the New World. In North America
locusts are more usually called grasshoppers. Several species of the
genus Caloptenus are injurious in that country, but the chief
migratory species is C. spretus (Fig. 175). This genus belongs to
Acridiides. A large locust, Schistocerca americana, is also migratory
to a small extent in the United States. In South America other
species of Schistocerca are migratory; it is not known how many
there may be, and it is possible that one or more may prove to be the
S. peregrina of the Old World. A Chilian species, according to Mr. E.
C. Reed,[232] exhibits distinctions of colour similar to those that have
been observed in S. peregrina in Algeria.
Fig. 178.—Cephalocoema lineata, female, × ⅔. S. America. (After

Brunner.)
In Britain we are now exempt from the ravages of locusts, though

swarms are said to have visited England in 1693 and 1748.
Individuals of the migratory species are, however, still occasionally
met with in England and the south of Scotland. P. cinerascens has
been recorded from Kerry in Ireland, but erroneously, the Insect
found being Mecostethus grossus (Fig. 173). According to Miss
Ormerod,[233] large locusts are imported to this country in fodder in
considerable numbers, but are usually dead; living individuals are,
however, sometimes found among the others. In 1869 living
specimens of Schistocerca peregrina were found in various parts of
the country, having, in all probability, arrived here by crossing the
German Ocean. Pachytylus cinerascens has also, it is believed,
occurred here, the specimens that have been recorded at different
times under the name of P. migratorius being more probably the
former species.
Although the majority of the very large number of species included in
Acridiidae are recognised with ease from their family likeness as
belonging to the group, yet there are others that present an unusual
aspect. This is specially the case with the members of the small
tribes Tettigides, Proscopides, and Pneumorides, and with some of
the apterous forms of the Oedipodides. The tribe Proscopides (Fig.
178, Cephalocoema lineata, female) includes some of the most
curious of the Acridiidae. Breitenbach gives[234] a brief account of
the habits of certain species which he met with near Porto Alegre in
South America. On a stony hill there was some grass which, by
several months' exposure to the sun's rays, had become withered
and brown. Apparently no live thing was to seen on this hillock
except the ubiquitous ants, but after a while he noticed some
"lightning-like" movements, which he found were due to specimens
of Proscopia. The Insects exactly resemble the withered vegetation
amongst which they sit, and when alarmed seek safety with a
lengthy and most rapid leap. When attention was thus directed to
them he found the Insects were really abundant, and was often able
to secure fifty specimens on a single afternoon. These Insects bear a
great general resemblance to the Phasmides, but there is no
evidence at present to show that the two kinds of Insects live in
company, as is the case with so many of the Insects that resemble
one another in appearance. Although the linear form and the
elongation of the body are common to the stick-Insects and the
Proscopides, yet this structure is due to the growth of different parts
in the two families. In the Phasmidae the prothorax is small, the
mesothorax elongate, while in the Proscopides the reverse is the
case. The elongation of the head is very curious in these Insects; the
mouth is not thus brought any nearer to the front, but is placed on
the under side of the head, quite close to the thorax. The tribe
Tryxalides contains Insects (Fig. 165) that approach the Proscopides
in the form of the head and other characters. In most cases the
sexes of the Proscopides differ from one another so strongly that it is
difficult to recognise them as being of the same species. Usually
both sexes are entirely apterous, but the Chilian genus Astroma
exhibits a remarkable exception and an almost unique condition of
the alar organs, the mesonotum being in each sex entirely destitute
of such appendages, while the female has on the metanotum
rudiments of wings which are absent in the male.
Fig. 179.—Tettix bipunctatus. Britain. A, The Insect magnified; B, part

of the middle of the body; a, prolongation of pronotum; b, tegmen;
c, wing.
The tribe Tettigides is a very extensive group of small Acridiidae, in

which the pronotum extends backwards as a hood and covers the
body, the tegmina and wings being more or less modified. In our
British species (Fig. 179) this condition does not greatly modify the
appearance of the Insect, but in many exotic species (Fig. 180) the
hood assumes remarkable developments, so that the Insects have
no longer the appearance of Orthoptera. It would be impossible,
without the aid of many figures, to give an idea of the variety of forms
assumed by this prothoracic expansion. It is a repetition of what
occurs in the Order Hemiptera, where the prothoracic hoods of the
Membracides exhibit a similar, though even more extraordinary,
series of monstrous forms. So great is the general similarity of the
two groups that when the genus Xerophyllum (Fig. 180, A) was for
the first time described, it was treated by the describer as being a
bug instead of a grasshopper. This genus includes several species
from Africa. The curious Cladonotus (Fig. 180, B) is a native of
Ceylon, where it is said to live in sandy meadows, after the fashion
of our indigenous species of Tettix (Fig. 179). Very little is known as
to the habits of these curious Tettigides, but it has been ascertained
that some of the genus Scelimena are amphibious, and do not
hesitate to enter the water and swim about there; indeed it is said
that they prefer plants growing under water as food. This habit has
been observed both in Ceylon and the Himalayas. The species are
said to have the hind legs provided with dilated foliaceous
appendages useful for swimming.
Fig. 180.—Tettigides: A, Xerophyllum simile Fairm.; B, Cladonotus
humbertianus. (After Bolivar.)
Fig. 181.—A, Mastax (Erianthus) guttatus, male. Sumatra. (After

Westwood.) B, profile; C, front of head.
The tribe Mastacides includes thirty or forty species of Acridiidae

with short antennae and vertical head (Fig. 181, Mastax guttatus);
they are apparently all rare and little known, but are widely
distributed in the tropics of the Old and New Worlds. Nothing
whatever seems to be known of their habits or of their development.
The tribe Pneumorides includes a still smaller number of species of

very aberrant and remarkable grasshoppers, of large size, with short
antennae, and with the pronotum prolonged and hood-like; they are
peculiar to South Africa. Although amongst the most remarkable of
Insects, we are not able to give any information as to their habits. It
would appear from the form of their legs that they have but little
power of hopping. The species of which we figure the female (Fig.
182) is very remarkable from the difference in colour of the sexes.
The female is so extravagantly coloured that she has been said to
look as if "got up" for a fancy-dress ball. She is of a gay green, with
pearly white marks, each of which is surrounded by an edging of
magenta; the white marks are very numerous, especially on the
parts of the body not shown in our figure; the face has magenta
patches and a large number of tiny pearly-white tubercles, each of
which, when placed on a green part, is surrounded by a little ring of
mauve colour. Though the female is certainly one of the most
remarkably coloured of Insects, her consort is of a modest, almost
unadorned green colour, and is considerably different in form. He is,
however, provided with a musical apparatus, which it is possible may
be a means of pleasing his gorgeous but dumb spouse. It consists of
a series of ridges placed on each side of the inflated abdomen,
which, as we have previously (p. 200) remarked, has every
appearance of being inflated with the result of improving its
resonance.
Fig. 182.—Pneumora scutellaris, female. South Africa.
The Pyrgomorphides[235] is a small tribe of about 120 described

species, two of which are found in the south of Europe (Fig. 183,
Pyrgomorpha grylloides). The tribe includes a number of large and
curious Insects, among them the species of Phymateus and Petasia,
with peculiar excrescences on the pronotum and vivid colours on
some parts of the body or its appendages, which are apparently
common Insects in South Africa.
The tribe Tryxalides includes a great many species of grasshoppers.

In them the front of the head joins the upper part at an acute angle
(Figs. 165 and 173). This tribe and the Acridiides are the most
numerous in species of the family. To the latter belong most of the
migratory locusts of the New World (Fig. 175, Caloptenus spretus). A
Spanish species of this tribe, Euprepocnemis plorans, though
provided with well-developed wings, possesses the remarkable habit
of seeking shelter by jumping into the water and attaching itself
below the surface to the stems of plants.
Fig. 183.—Pyrgomorpha grylloides. South Europe. (After Fischer.)
Fig. 184.—Xiphocera (Hoplolopha) asina. S. Africa. (After de

Saussure.)
The tribe Pamphagides[236] includes some 200 species, found

chiefly in Africa and the arid regions near the Mediterranean Sea.
They are mostly apterous forms, and this circumstance has,
according to de Saussure, exercised a marked influence on the
geographical distribution of the species. Although the tribe consists
chiefly of apterous forms, several species possess well-developed
wings; sometimes this is the case of the male but not of the female.
Some of the species are highly modified for a desert life, and exhibit
a great variation in the colour of the individuals in conformity with the
tint of the soil they inhabit. Xiphocera asina (Fig. 184) is thought by
Péringuey to be the prey of the extraordinary South African tiger-
beetles of the genus Manticora.
We have already mentioned the tribe Oedipodides[237] as including

most of the species of migratory locusts of the Old World. Some
striking cases of variation in colour occur amongst the winged
Oedipodides. In certain species the hind wings may be either blue or
rosaceous in colour; it is thought that the latter is the tint natural in
the species, and that it is due to the mixture of a red pigment with the
pale blue colour of the wing; hence the blue-coloured wings are
analogous to cases of albinism. But the most remarkable fact is that
this colour difference is correlative with locality. Brunner von
Wattenwyl says[238] that the blue variety of Oe. variabilis occurs only
in a few localities in Europe—he mentions Vienna and Sarepta,—
and that where it occurs not a single red example can be met with.
Similar phenomena occur in other species in both Europe and North
America, and L. Bruner has suggested[239] that the phenomena in
the latter country are correlative with climatic conditions.
The group Eremobiens, a subdivision of Oedipodides, includes some

of the most interesting forms of Acridiidae. Its members have several
modes of stridulation. Cuculligera flexuosa and other of the winged
forms, according to Pantel,[240] produce sounds by the friction of the
middle tibia against the wing, both of these parts being specially
modified for the purpose in the male sex. The most peculiar
members of the Eremobiens are some very large Insects, modified
to an extraordinary extent for a sedentary life in deserts and arid
places. Trimen says[241] that a South African species, Trachypetra
bufo, which lives amongst stones, is so coloured that he had much
difficulty in detecting it, and that he noticed in certain spots, often
only a few square yards in extent, where the stones lying on the
ground were darker, lighter, or more mottled than usual, that the
individuals of the grasshopper were of a similar colour to the stones.
Fig. 185.—Methone anderssoni, female. S. Africa. a, Front of head; b,
posterior leg; c, d, front and hind feet. (c and d magnified, the
others natural size.)
The Insect referred to by Trimen is, we believe, the Batrachotettix

whiti of de Saussure. In this species the alar organs are completely
absent, and the pronotum forms a sort of hood that protects the base
of the hind body. Some of the desert Eremobiens vary so much that
the differences found among individuals of the same species are
said by Brunner and de Saussure to be so great as to affect even the
generic characters, and give rise to the idea of an "uncompleted
species-formation."
Fig. 186.—Portions of middle of the body and hind leg of Methone

anderssoni ♂ : a, femur; b, an inferior fold; c, rattling-plate; d,
striated surface; e, the adjoining sculpture; f, grooved portion of
tegmen. The part e is really, like d, a portion of the second
abdominal segment, not of the third, as might be supposed from
the figure.
Methone anderssoni, an inhabitant of the Karoo Desert of South

Africa, is one of the largest of the Acridiidae. A female of this species
is represented of the natural size in Fig. 185. This Insect is
remarkable on account of the complex organs for producing sound,
and for the great modification of the posterior legs (Fig. 185, b),
which do not possess locomotive functions, but serve as a portion of
the sound-producing apparatus, and as organs for protecting the
sides of the body. This Insect is said to be very efficient in making a
noise. The sexes differ considerably in their sound-producing
organs, a portion of which are present in the female as well as in the
male (Fig. 186). Connected with the first abdominal segment, but
extending backwards on the second, there is a peculiar swelling
bearing two or three strongly raised chitinous folds (Fig. 186, c).
When the leg is rotated these folds are struck by some peg-like
projections situate on the inner face of the base of the femur, and a
considerable noise is thus produced. The pegs cannot be seen in
our figure. This apparatus is equally well developed in female and
male. On the second abdominal segment, immediately behind the
creaking folds we have described, there is a prominent area, densely
and finely striated (Fig. 186, d): this is rubbed by some fine asperities
on the inner part of the femur near its base. Sound is produced by
this friction on the striated surface, the sculpture of which is abruptly
contrasted with that of the contiguous parts: these structures seem
to be somewhat better developed in the male than they are in the
female, and to be phonetic, at any rate in the former sex. The male
has the rudimentary tegmina (Fig. 186, f) much longer than they are
in the female (Fig. 185), and their prolonged part is deeply grooved,
so as to give rise to strong ridges, over which plays the edge of the
denticulate and serrate femur. There is nothing to correspond to this
in the female, and friction over the surface of this part of the male
produces a different and louder sound. There can be little doubt that
this is a phonetic structure peculiar to the male. It approximates in
situation to the sound-producing apparatus of the males of the
Stenobothri and other Acridiidae. Methone anderssoni has large

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PV 5 3 CF1 3 DF1,k 4 1 . . . 3 CFt 3 DFt,k 4 1 . . . 1 3 CFT 3 DFT,k 4

5. Present value of an annuity (Chapter 2, equation 2.11)

6. Sharpe ratio of asset i (Chapter 3, equation 3.8)

Cov 1 Ri, RM 2 riMsisM si

Invested capital 5 Cash 1 Working capital requirement 1 Net fixed assets

10. Capital employed (Chapter 4, equation 4.6)

WCR 5 3 Accounts receivable 1 Inventories 1 Prepaid expenses 4

15. Return on invested capital before tax (Chapter 6, equation 6.4)

EBIT EBIT Sales

16. The structure of a firm’s return on equity (Chapter 6, equation 6.9)

EBIT Sales EBT Invested capital EAT

SGR 5 Profit retention rate 3 Return on equity

18. Net present value (Chapter 7)

19. Bond price (Chapter 10, equation 10.2)

21. Constant dividend growth model (Chapter 10, equation 10.10)

23. Equity (levered) beta (Chapter 12, equation 12.6)

24. Weighted average cost of capital (Chapter 12, equation 12.12)

26. Market value of a levered firm (Chapter 13, equation 13.4)

27. Market value at risk (Chapter 15, equation 15.1)

MVR 5 3 Reduction in the firm’s value if the risk will occur 4

C0 1 call option 2 5 S0N 1 d1 2 2 Xe2R TN 1 d2 2 F

P0 1 put option 2 5 Xe2R T 3 1 2 N 1 d2 2 4 2 S0 3 1 2 N 1 d2 2 4

30. Market value added (Chapter 18, equation 18.1)

Market value added 1 MVA 2 5 Market value of capital 2 Capital employed

31. Return on invested capital (Chapter 18)

32. Economic value added (Chapter 18, equation 18.6)

EVA 5 3 Return spread 4 3 Invested capital 5 3 ROIC 2 WACC 4 3 Invested capital

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PART ii Assessing Business Performance 99

PART iii Making Investment Decisions 227

PART iV Making Financing Decisions 315

PART V Making Business Decisions 487

PART i Financial Concepts and Techniques 1

chapter 2 The Time Value of Money 31

Appendix 2.1 Proof of Formula 2.9 and Formula 2.6 49

chapter 3 Risk and Return 53

Appendix 3.1 How to Get the SML Equation 93

PART ii Assessing Business Performance 99

Appendix 4.2 Specimen Financial Statements 136

chapter 5 Analyzing Operational Efficiency and Liquidity 153

A p p e n d i x 5 . 1 Financing Strategies 173

A p p e n d i x 5 . 2 The GlaxoSmithKline Liquidity and Operational Efficiency 176

chapter 6 Analyzing Profitability, Risk, and Growth 189

A p p e n d i x 6 . 1 Glaxosmithkline�s Profitability 213

PART iii Making Investment Decisions 227

A Two-Period Investment with an Intermediate Cash Flow 235

chapter 8 Alternatives to the Net Present Value Rule 261

chapter 9 Identifying and Estimating a Project’s Cash Flows 287

PART iV Making Financing Decisions 315

The Term Structure of Interest Rates 329

A p p e n d i x 1 0 . 1 The Properties of Duration 350

A p p e n d i x 5 . 2 The GlaxoSmithKline Liquidity and Operational Efficiency 176

chapter 1 6 Understanding Forward, Futures, and Options and Their

A p p e n d i x 1 7 . 1 Translating Financial Statements with the Monetary/

A p p e n d i x 1 8 . 1 Adjusting Book Values to Estimate the Amount of Invested Equity