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 GLOBAL
EDITION

Fundamentals of
Corporate Finance
FIFTH EDITION

Jonathan Berk   Peter DeMarzo   Jarrad Harford

 Fundamentals of

Corporate Finance
FIFTH EDITION
GLOBAL EDITION

Jonathan Peter Jarrad

Berk DeMarzo Harford
STANFORD UNIVERSITY STANFORD UNIVERSITY UNIVERSITY OF WASHINGTON

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Authorized adaptation from the United States edition, entitled Fundamentals of

Corporate Finance, 5th Edition, ISBN 978-0-13-581159-7 by Jonathan B. Berk,
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 To Natasha and Hannah for all the joy you
bring to my life. —J. B.

To Kaui, Pono, Koa, and Kai for all the love

and laughter. —P. D.

To Katrina, Evan, and Cole for your love and

support. —J. H.

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 Brief Contents

PART 1 Introduction 29
CHAPTER 1 Corporate Finance and the Financial Manager 31
CHAPTER 2 Introduction to Financial Statement Analysis 55

PART 2 Interest Rates and Valuing Cash Flows 99

CHAPTER 3 Time Value of Money: An Introduction 101
CHAPTER 4 Time Value of Money: Valuing Cash Flow Streams 121
CHAPTER 5 Interest Rates 159
CHAPTER 6 Bonds 187
CHAPTER 7 Stock Valuation 225

PART 3 Valuation and the Firm 253

CHAPTER 8 Investment Decision Rules 255
CHAPTER 9 Fundamentals of Capital Budgeting 293
CHAPTER 10 Stock Valuation: A Second Look 331

PART 4 Risk and Return 363

CHAPTER 11 Risk and Return in Capital Markets 365
CHAPTER 12 Systematic Risk and the Equity Risk Premium 397
CHAPTER 13 The Cost of Capital 433

PART 5 Long-Term Financing 461

CHAPTER 14 Raising Equity Capital 463
CHAPTER 15 Debt Financing 495

PART 6 Capital Structure and Payout Policy 523

CHAPTER 16 Capital Structure 525
CHAPTER 17 Payout Policy 565

PART 7 Financial Planning and Forecasting 599

CHAPTER 18 Financial Modeling and Pro Forma Analysis 601
CHAPTER 19 Working Capital Management 631
CHAPTER 20 Short-Term Financial Planning 657

PART 8 Special Topics 687

CHAPTER 21 Option Applications and Corporate Finance 689
CHAPTER 22 Mergers and Acquisitions 715
CHAPTER 23 International Corporate Finance 745 5

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 Detailed Contents
PART 1 Introduction 29
CHAPTER 1 Corporate Finance and the
Financial Manager 31
1.1 Why Study Finance? 32
1.2 The Four Types of Firms 32
Sole Proprietorships 33
Partnerships 34
Limited Liability Companies 34
Corporations 34
Tax Implications for Corporate Entities 36
• Corporate Taxation Around the World 36
1.3 The Financial Manager 38
Making Investment Decisions 38
• GLOBAL FINANCIAL CRISIS The
Dodd-Frank Act 38
Making Financing Decisions 39
Managing Short-Term Cash Needs 39
The Goal of the Financial Manager 39
• Shareholder Value Versus Stakeholder
Value 40
1.4 The Financial Manager’s Place in the
Corporation 40
The Corporate Management Team 40
Ethics and Incentives in Corporations 41
• GLOBAL FINANCIAL CRISIS The
Dodd-Frank Act on Corporate Compensation
and Governance 42
• Citizens United v. Federal Election
Commission 42
1.5 The Stock Market 43
The Largest Stock Markets 43
Primary Versus Secondary Markets 44
Traditional Trading Venues 44
• INTERVIEW WITH Frank Hatheway 45
New Competition and Market Changes 46
Dark Pools 47
Listing Standards 47
Other Financial Markets 47
• NYSE, BATS, DJIA, S&P 500: Awash in
Acronyms 48
1.6 Financial Institutions 48
The Financial Cycle 48
Types of Financial Institutions 49
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Role of Financial Institutions 49
Summary 51 ● Problems 52
CHAPTER 2 Introduction to Financial
Statement Analysis 55
2.1 Firms’ Disclosure of Financial Information 56
Preparation of Financial Statements 56
• International Financial Reporting
Standards 56
• INTERVIEW WITH Ruth Porat 57
Types of Financial Statements 58
2.2 The Balance Sheet 58
Assets 59
Liabilities 60
Stockholders’ Equity 60
Market Value Versus Book Value 61
Market-to-Book Ratio 62
Enterprise Value 62
2.3 The Income Statement 64
Earnings Calculations 64
EBITDA 65
2.4 The Statement of Cash Flows 66
Operating Activity 66
Investment Activity 69
Financing Activity 69
2.5 Other Financial Statement Information 69
Statement of Stockholders’ Equity 70
Management Discussion and Analysis 70
Notes to the Financial Statements 70
2.6 Financial Statement Analysis 70
Profitability Ratios 71
Liquidity Ratios 72
Asset Efficiency 72
Working Capital Ratios 72
Interest Coverage Ratios 74
Leverage Ratios 74
Valuation Ratios 76
• COMMON MISTAKE Mismatched
Ratios 76
Operating Returns 77
The DuPont Identity 78
2.7 Financial Reporting in Practice 82
Enron 82
The Sarbanes-Oxley Act 82
7
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 8 Detailed Contents

Dodd-Frank Act 83 • Historical Examples of Perpetuities 128

• GLOBAL FINANCIAL CRISIS Bernard • COMMON MISTAKE Discounting One Too
Madoff’s Ponzi Scheme 84 Many Times 129
The Financial Statements: A Useful Starting
4.3 Annuities 129
Point 84
Present Value of an Annuity 129
Summary 85 ● Critical Thinking 87 ●
Future Value of an Annuity 132
Problems 88 ● Data Case 96
4.4 Growing Cash Flows 133
Growing Perpetuity 134
Growing Annuity 136
PART 2 Interest Rates and
4.5 Solving for Variables Other Than Present Value
Valuing Cash Flows 99 or Future Value 137
Solving for the Cash Flows 137
CHAPTER 3 Time Value of Money: An
Rate of Return 140
Introduction 101 Solving for the Number of Periods 143
3.1 Cost-Benefit Analysis 102 4.6 Non-Annual Cash Flows 144
Role of the Financial Manager 102 The Big Picture 145
Quantifying Costs and Benefits 102 Summary 146 ● Critical Thinking 147 ●
3.2 Market Prices and the Valuation Principle 104 Problems 147 ● Data Case 153
The Valuation Principle 104 CHAPTER 4 APPENDIX Using a Financial
Why There Can Be Only One Competitive Price for Calculator 155
a Good 105
• Your Personal Financial Decisions 106 CHAPTER 5 Interest Rates 159
3.3 The Time Value of Money and Interest
5.1 Interest Rate Quotes and Adjustments 160
Rates 106
The Effective Annual Rate 160
The Time Value of Money 106
Adjusting the Discount Rate to Different Time
The Interest Rate: Converting Cash Across
Periods 161
Time 107
Annual Percentage Rates 162
Timelines 110
• COMMON MISTAKE Using the EAR in the
3.4 Valuing Cash Flows at Different Points in Annuity Formula 163
Time 111
5.2 Application: Discount Rates and Loans 165
Rule 1: Comparing and Combining Values 111
Computing Loan Payments 165
• COMMON MISTAKE Summing Cash Flows • GLOBAL FINANCIAL CRISIS Teaser Rates
Across Time 111
and Subprime Loans 167
Rule 2: Compounding 112
Computing the Outstanding Loan Balance 167
• Rule of 72 113
Rule 3: Discounting 114 5.3 The Determinants of Interest Rates 168
Inflation and Real Versus Nominal Rates 169
• Using a Financial Calculator 116
Summary 116 ● Critical Thinking 117 ● Investment and Interest Rate Policy 170
Problems 117 • How Is Inflation Actually Calculated? 171
The Yield Curve and Discount Rates 172
CHAPTER 4 Time Value of Money: Valuing • INTERVIEW WITH Dr. Janet Yellen 174
Cash Flow Streams 121 • COMMON MISTAKE Using the Annuity
Formula When Discount Rates Vary 175
4.1 Valuing a Stream of Cash Flows 122 The Yield Curve and the Economy 175
Applying the Rules of Valuing Cash Flows to a 5.4 The Opportunity Cost of Capital 178
Cash Flow Stream 122 • Interest Rates, Discount Rates, and the Cost
• Using a Financial Calculator: Solving for of Capital 179
Present and Future Values of Cash Flow • COMMON MISTAKE States Dig a $3 Trillion
Streams 125 Hole by Discounting at the Wrong Rate 180
4.2 Perpetuities 126 Summary 180 ● Critical Thinking 182 ●
Perpetuities 126 Problems 182

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CHAPTER 6 Bonds 187
6.1 Bond Terminology 188
6.2 Zero-Coupon Bonds 189
Zero-Coupon Bond Cash Flows 190
Yield to Maturity of a Zero-Coupon Bond 190
• GLOBAL FINANCIAL CRISIS Negative Bond
Yields 191
Risk-Free Interest Rates 192
6.3 Coupon Bonds 193
Coupon Bond Cash Flows 193
• The U.S. Treasury Market 194
Yield to Maturity of a Coupon Bond 195
• Finding Bond Prices on the Web 197
Coupon Bond Price Quotes 198
6.4 Why Bond Prices Change 198
Interest Rate Changes and Bond Prices 198
Time and Bond Prices 201
Interest Rate Risk and Bond Prices 202
• Clean and Dirty Prices for Coupon Bonds 205
Bond Prices in Practice 205
6.5 Corporate Bonds 206
Credit Risk 207
• Are Treasuries Really Default-Free
Securities? 207
• INTERVIEW WITH Lisa Black 208
Corporate Bond Yields 208
Bond Ratings 209
Corporate Yield Curves 209
• The Credit Crisis and Bond Yields 211
Summary 213 ● Critical Thinking 214 ●
Problems 214 ● Data Case 218
CHAPTER 6 APPENDIX A Solving for the
Yield to Maturity of a Bond Using a Financial
Calculator 220
CHAPTER 6 APPENDIX B The Yield Curve and
the Law of One Price 221
CHAPTER 7 Stock Valuation 225
7.1 Stock Basics 226
Stock Market Reporting: Stock Quotes 226
Common Stock 227
Preferred Stock 228
7.2 The Mechanics of Stock Trades 229
7.3 The Dividend-Discount Model 230
A One-Year Investor 230
Dividend Yields, Capital Gains, and Total
Returns 231
A Multiyear Investor 232
Dividend-Discount Model Equation 233
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7.4 Estimating Dividends in the Dividend-Discount
Model 234
Constant Dividend Growth 234
Dividends Versus Investment and Growth 235
Changing Growth Rates 237
• COMMON MISTAKE Forgetting to “Grow”
This Year’s Dividend 238
Value Drivers and the Dividend-Discount Model 240
7.5 Limitations of the Dividend-Discount Model 240
Uncertain Dividend Forecasts 240
Non-Dividend-Paying Stocks 241
7.6 Share Repurchases and the Total Payout
Model 242
7.7 Putting It All Together 243
Summary 244 ● Critical Thinking 246 ●
Problems 246
PART 2 INTEGRATIVE CASE 250
PART 3 Valuation and the
Firm 253
CHAPTER 8 Investment Decision Rules 255
8.1 The NPV Decision Rule 256
Net Present Value 256
The NPV Decision Rule 257
8.2 Using the NPV Rule 258
Organizing the Cash Flows and Computing the
NPV 258
The NPV Profile 259
Measuring Sensitivity with IRR 260
Alternative Rules Versus the NPV Rule 260
8.3 Alternative Decision Rules 260
• USING EXCEL Computing NPV and
IRR 261
The Payback Rule 262
The Internal Rate of Return Rule 263
• COMMON MISTAKE IRR Versus the IRR
Rule 267
Modified Internal Rate of Return 267
• Why Do Rules Other Than the NPV Rule
Persist? 268
8.4 Choosing Among Projects 270
Differences in Scale 271
• INTERVIEW WITH Dick Grannis 274
Timing of the Cash Flows 275
8.5 Evaluating Projects with Different
Lives 276
Important Considerations When Using the
­Equivalent Annual Annuity 278
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 10 Detailed Contents

8.6 Choosing Among Projects When Resources Are

CHAPTER 10 Stock Valuation: A Second
Limited 279
Look 331
Evaluating Projects with Different Resource
Requirements 279 10.1 The Discounted Free Cash Flow Model 332
8.7 Putting It All Together 282 Valuing the Enterprise 332
Summary 283 ● Critical Thinking 284 ● Implementing the Model 333
Problems 285 ● Data Case 291 Connection to Capital Budgeting 334
CHAPTER 8 APPENDIX Creating the NPV 10.2 Valuation Based on Comparable Firms 336
Profile Using Excel's Data Table Function 292 Valuation Multiples 336
Limitations of Multiples 341
CHAPTER 9 Fundamentals of Capital Comparison with Discounted Cash Flow
Budgeting 293 Methods 342
10.3 Stock Valuation Techniques: A Final Word 342
9.1 The Capital Budgeting Process 294 • INTERVIEW WITH Douglas Kehring 343
9.2 Forecasting Incremental Earnings 295 10.4 Information, Competition, and Stock
Operating Expenses Versus Capital Prices 344
Expenditures 295 Information in Stock Prices 344
Incremental Revenue and Cost Estimates 296 Competition and Efficient Markets 346
Taxes 297 • Forms of Market Efficiency 346
Incremental Earnings Forecast 297 Lessons for Investors and Corporate
9.3 Determining Incremental Free Cash Flow 299 Managers 348
Converting from Earnings to Free Cash • Nobel Prize The 2013 Prize: An
Flow 300 Enigma? 349
Calculating Free Cash Flow Directly 303 The Efficient Markets Hypothesis Versus No
Calculating the NPV 304 Arbitrage 349
• USING EXCEL Capital ­Budgeting Using a 10.5 Individual Biases and Trading 350
­Spreadsheet Program 305 Excessive Trading and Overconfidence 350
9.4 Other Effects on Incremental Free Cash Hanging On to Losers and the Disposition
Flows 306 Effect 350
Opportunity Costs 306 Investor Attention, Mood, and Experience 352
• COMMON MISTAKE The Opportunity Cost Summary 353 ● Critical Thinking 354 ●
of an Idle Asset 306 Problems 354 ● Data Case 359
Project Externalities 306 PART 3 INTEGRATIVE CASE 361
Sunk Costs 307
• COMMON MISTAKE The Sunk Cost
Fallacy 307 PART 4 Risk and Return 363
Adjusting Free Cash Flow 308
CHAPTER 11 Risk and Return in Capital
Replacement Decisions 310
Markets 365
9.5 Analyzing the Project 311
Sensitivity Analysis 311 11.1 A First Look at Risk and Return 366
Break-Even Analysis 312 11.2 Historical Risks and Returns of Stocks 368
• INTERVIEW WITH David Holland 314 Computing Historical Returns 369
Scenario Analysis 315 Average Annual Returns 371
• USING EXCEL Project Analysis Using • Arithmetic Average Returns Versus
Excel 316 ­Compound Annual Returns 373
9.6 Real Options in Capital Budgeting 317 The Variance and Volatility of Returns 374
Option to Delay 318 • COMMON MISTAKE Mistakes When
Option to Expand 318 Computing Standard Deviation 376
Option to Abandon 318 • USING EXCEL Computing the Standard
Summary 319 ● Critical Thinking 320 ● ­Deviation of Historical Returns 376
Problems 320 ● Data Case 328 The Normal Distribution 377
CHAPTER 9 APPENDIX MACRS 11.3 The Historical Tradeoff Between Risk and
Depreciation 329 Return 379

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 Detailed Contents 11

The Returns of Large Portfolios 379 The Big Picture 422

The Returns of Individual Stocks 379 Summary 422 ● Critical Thinking 424 ●
11.4 Common Versus Independent Risk 381 Problems 424
Theft Versus Earthquake Insurance: An CHAPTER 12 APPENDIX Alternative Models of
Example 381 Systematic Risk 429
Types of Risk 381
11.5 Diversification in Stock Portfolios 383 CHAPTER 13 The Cost of Capital 433
Unsystematic Versus Systematic Risk 383
• GLOBAL FINANCIAL CRISIS Diversification 13.1 A First Look at the Weighted Average Cost of
Benefits During Market Crashes 384 Capital 434
Diversifiable Risk and the Risk Premium 386 The Firm’s Capital Structure 434
The Importance of Systematic Risk 386 Opportunity Cost and the Overall Cost of
• COMMON MISTAKE A Fallacy of Long-Run Capital 434
Diversification 387 Weighted Averages and the Overall Cost of
Summary 388 ● Critical Thinking 389 ● Capital 435
Problems 390 ● Data Case 393 Weighted Average Cost of Capital
Calculations 436
CHAPTER 12 Systematic Risk and the Equity 13.2 The Firm’s Costs of Debt and Equity Capital 437
Risk Premium 397 Cost of Debt Capital 437
• COMMON MISTAKE Using the Coupon Rate
12.1 The Expected Return of a Portfolio 398 as the Cost of Debt 438
Portfolio Weights 398 Cost of Preferred Stock Capital 439
Portfolio Returns 398 Cost of Common Stock Capital 440
Expected Portfolio Return 400
13.3 A Second Look at the Weighted Average Cost of
12.2 The Volatility of a Portfolio 401 Capital 442
Diversifying Risks 401 WACC Equation 442
Measuring Stocks’ Co-Movement: Weighted Average Cost of Capital in
Correlation 403 Practice 443
• USING EXCEL Calculating the Correlation Methods in Practice 444
Between Two Sets of Returns 405
13.4 Using the WACC to Value a Project 445
Computing a Portfolio’s Variance and Standard
Key Assumptions 446
Deviation 405
WACC Method Application: Extending the Life of
The Volatility of a Large Portfolio 407
an AT&T Facility 447
• Nobel Prize Harry Markowitz 408 Summary of the WACC Method 448
12.3 Measuring Systematic Risk 409
13.5 Project-Based Costs of Capital 448
Role of the Market Portfolio 409
Stock Market Indexes as the Market
• COMMON MISTAKE Using a Single Cost of
Capital in Multi-Divisional Firms 448
Portfolio 410
Cost of Capital for a New Acquisition 449
Market Risk and Beta 410
Divisional Costs of Capital 449
• Index Funds 411 • INTERVIEW WITH Shelagh Glaser 450
• COMMON MISTAKE Mixing Standard
Deviation and Beta 413 13.6 When Raising External Capital Is Costly 451
Estimating Beta from Historical Returns 414 Summary 452 ● Critical Thinking 454 ●
Problems 454 ● Data Case 457
• USING EXCEL Calculating a Stock’s Beta 416
12.4 Putting It All Together: The Capital Asset Pricing PART 4 INTEGRATIVE CASE 459
Model 416
The CAPM Equation Relating Risk to Expected PART 5 Long-Term
Return 416
Financing 461
• Why Not Estimate Expected Returns
Directly? 417 CHAPTER 14 Raising Equity Capital 463
• Nobel Prize William Sharpe 418
The Security Market Line 419 14.1 Equity Financing for Private Companies 464
The CAPM and Portfolios 421 Sources of Funding 464
Summary of the Capital Asset Pricing Model 422 • INTERVIEW WITH Kevin Laws 465

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 12 Detailed Contents
• Crowdfunding: The Wave of the Future?
Securities and Valuation 467
Exiting an Investment in a Private Company 469
14.2 Taking Your Firm Public: The Initial Public
Offering 470
Advantages and Disadvantages of Going Public 470
Primary and Secondary IPO Offerings 470
Other IPO Types 476
• Google’s IPO 477
• An Alternative to the Traditional IPO: Spotify's
Direct Listing 479
14.3 IPO Puzzles 479
Underpriced IPOs 480
“Hot” and “Cold” IPO Markets 481
• GLOBAL FINANCIAL CRISIS 2008–2009:
A Very Cold IPO Market 482
High Cost of Issuing an IPO 482
Poor Post-IPO Long-Run Stock Performance 483
14.4 Raising Additional Capital: The Seasoned Equity
Offering 484
SEO Process 484
SEO Price Reaction 486
SEO Costs 487
Summary 488 ● Critical Thinking 489 ●
Problems 489 ● Data Case 492
CHAPTER 15 Debt Financing 495
15.1 Corporate Debt 496
Private Debt 496
• Debt Financing at Hertz: Bank Loans 496
• Debt Financing at Hertz: Private
Placements 497
Public Debt 497
• Debt Financing at Hertz: Public Debt 499
15.2 Other Types of Debt 501
Sovereign Debt 501
Municipal Bonds 502
• Detroit’s Art Museum at Risk 503
Asset-Backed Securities 503
• GLOBAL FINANCIAL CRISIS CDOs,
Subprime Mortgages, and the Financial
Crisis 504
15.3 Bond Covenants 506
Types of Covenants 506
Advantages of Covenants 506
Application: Hertz’s Covenants 507
15.4 Repayment Provisions 507
Call Provisions 507
• New York City Calls Its Municipal
Bonds 509
Sinking Funds 510
Convertible Provisions 510
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467 Summary 513 ● Critical Thinking 515 ●
Problems 515 ● Data Case 517
CHAPTER 15 APPENDIX Using a Financial
­Calculator to Calculate Yield to Call 518
PART 5 INTEGRATIVE CASE 519
PART 6 Capital Structure and
Payout Policy 523
CHAPTER 16 Capital Structure 525
16.1 Capital Structure Choices 526
Capital Structure Choices Across Industries 526
Capital Structure Choices Within Industries 526
16.2 Capital Structure in Perfect Capital Markets 528
Application: Financing a New Business 529
Leverage and Firm Value 530
The Effect of Leverage on Risk and Return 531
Homemade Leverage 533
Leverage and the Cost of Capital 533
• COMMON MISTAKE Capital Structure
Fallacies 534
• GLOBAL FINANCIAL CRISIS Bank Capital
Regulation and the ROE Fallacy 536
MM and the Real World 537
• Nobel Prize Franco Modigliani and Merton
Miller 537
16.3 Debt and Taxes 538
The Interest Tax Deduction and Firm Value 538
Value of the Interest Tax Shield 539
The Interest Tax Shield with Permanent Debt 541
Leverage and the WACC with Taxes 542
Debt and Taxes: The Bottom Line 542
16.4 The Costs of Bankruptcy and Financial
Distress 543
Direct Costs of Bankruptcy 544
• Bankruptcy Can Be Expensive 544
Indirect Costs of Financial Distress 544
16.5 Optimal Capital Structure: The Tradeoff
Theory 545
Differences Across Firms 545
Optimal Leverage 546
16.6 Additional Consequences of Leverage: Agency
Costs and Information 547
Agency Costs 547
• Airlines Use Financial Distress to Their
Advantage 548
• GLOBAL FINANCIAL CRISIS Moral Hazard
and Government Bailouts 549
• Financial Distress and Rolling the Dice,
Literally 550
Debt and Information 550
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16.7 Capital Structure: Putting It All Together 552
Summary 553 ● Critical Thinking 555 ●
Problems 555
CHAPTER 16 APPENDIX The Bankruptcy
Code 563
CHAPTER 17 Payout Policy 565
17.1 Cash Distributions to Shareholders 566
Dividends 567
Share Repurchases 568
17.2 Dividends Versus Share Repurchases in a
­Perfect Capital Market 569
Alternative Policy 1: Pay a Dividend with Excess
Cash 570
Alternative Policy 2: Share Repurchase
(No Dividend) 570
• COMMON MISTAKE Repurchases and the
Supply of Shares 572
Alternative Policy 3: High Dividend (Equity
Issue) 572
Modigliani-Miller and Dividend Policy
Irrelevance 573
• COMMON MISTAKE The Bird in the Hand
Fallacy 574
Dividend Policy with Perfect Capital
Markets 574
17.3 The Tax Disadvantage of Dividends 575
Taxes on Dividends and Capital
Gains 575
Optimal Dividend Policy with Taxes 575
Tax Differences Across Investors 578
17.4 Payout Versus Retention of Cash 580
Retaining Cash with Perfect Capital
Markets 580
Retaining Cash with Imperfect Capital
Markets 581
17.5 Signaling with Payout Policy 584
Dividend Smoothing 584
Dividend Signaling 585
• Royal & SunAlliance’s Dividend Cut 586
Signaling and Share Repurchases 586
• INTERVIEW WITH John Connors 587
17.6 Stock Dividends, Splits, and Spin-Offs 588
Stock Dividends and Splits 588
• Berkshire Hathaway’s A and
B Shares 589
Spin-Offs 589
17.7 Advice for the Financial Manager 590
Summary 591 ● Critical Thinking 593 ●
Problems 593 ● Data Case 596
PART 6 INTEGRATIVE CASE 598
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Detailed Contents 13
PART 7 Financial Planning and
Forecasting 599
CHAPTER 18 Financial Modeling and Pro
Forma Analysis 601
18.1 Goals of Long-Term Financial Planning 602
Identify Important Linkages 602
Analyze the Impact of Potential Business
Plans 602
Plan for Future Funding Needs 602
18.2 Forecasting Financial Statements: The Percent
of Sales Method 603
Percent of Sales Method 603
Pro Forma Income Statement 604
Pro Forma Balance Sheet 605
• COMMON MISTAKE Confusing
Stockholders’ Equity with Retained
Earnings 606
Making the Balance Sheet Balance: Net New
Financing 606
Choosing a Forecast Target 608
18.3 Forecasting a Planned Expansion 608
KMS Designs’ Expansion: Financing
Needs 609
KMS Designs’ Expansion: Pro Forma Income
Statement 610
• COMMON MISTAKE Treating Forecasts
as Fact 612
Forecasting the Balance Sheet 612
18.4 Growth and Firm Value 613
Sustainable Growth Rate and External
Financing 614
18.5 Valuing the Expansion 617
Forecasting Free Cash Flows 617
• COMMON MISTAKE Confusing Total
and Incremental Net Working
Capital 619
KMS Designs’ Expansion: Effect on Firm
Value 619
Optimal Timing and the Option to Delay 622
Summary 623 ● Critical Thinking 624 ●
Problems 624
CHAPTER 18 APPENDIX The Balance Sheet
and Statement of Cash Flows 628
CHAPTER 19 Working Capital
Management 631
19.1 Overview of Working Capital 632
The Cash Cycle 632
Working Capital Needs by Industry 634
Firm Value and Working Capital 635
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 14 Detailed Contents

19.2 Trade Credit 636 • A Seventeenth-Century Financing

Trade Credit Terms 637 Solution 671
Trade Credit and Market Frictions 637 Inventory as Collateral 672
• COMMON MISTAKE Using APR Instead of EAR • Loan Guarantees: The Ex-Im Bank
to C
­ ompute the Cost of Trade Credit 638 Controversy 672
Managing Float 639
20.6 Putting It All Together: Creating a Short-Term
19.3 Receivables Management 640 Financial Plan 674
Determining the Credit Policy 640 Summary 675 ● Critical Thinking 676 ●
• The 5 C’s of Credit 640 Problems 677
Monitoring Accounts Receivable 642
PART 7 INTEGRATIVE CASE 681
19.4 Payables Management 644
Determining Accounts Payable Days
Outstanding 644 PART 8 Special Topics 687
Stretching Accounts Payable 645
19.5 Inventory Management 646
CHAPTER 21 Option Applications and
Benefits of Holding Inventory 646 Corporate Finance 689
Costs of Holding Inventory 647
21.1 Option Basics 690
• Inventory Management Adds to the ­Bottom Option Contracts 690
Line at Gap 647
Stock Option Quotations 691
19.6 Cash Management 648 Options on Other Financial Securities 693
Motivation for Holding Cash 648 • Options Are for More Than Just Stocks 693
Alternative Investments 648
21.2 Option Payoffs at Expiration 693
• Hoarding Cash 650 The Long Position in an Option Contract 694
Summary 650 ● Critical Thinking 652 ●
The Short Position in an Option Contract 695
Problems 652 ● Data Case   655
Profits for Holding an Option to Expiration 697
Returns for Holding an Option to Expiration 699
CHAPTER 20 Short-Term Financial
Planning 657 21.3 Factors Affecting Option Prices 700
Strike Price and Stock Price 700
20.1 Forecasting Short-Term Financing Needs 658 Option Prices and the Exercise Date 700
Application: Springfield Snowboards, Inc. 658 Option Prices and the Risk-Free Rate 701
Negative Cash Flow Shocks 658 Option Prices and Volatility 701
Positive Cash Flow Shocks 659 21.4 The Black-Scholes Option Pricing
Seasonalities 659 Formula 702
The Cash Budget 661
21.5 Put-Call Parity 703
20.2 The Matching Principle 663 Portfolio Insurance 704
Permanent Working Capital 663
21.6 Options and Corporate Finance 707
Temporary Working Capital 663
Summary 709 ● Critical Thinking 710 ●
Permanent Versus Temporary Working
Problems 710 ● Data Case 712
Capital 663
Financing Policy Choices 664 CHAPTER 22 Mergers and Acquisitions 715
20.3 Short-Term Financing with Bank Loans 666
Single, End-of-Period Payment Loan 666 22.1 Background and Historical Trends 716
Line of Credit 666 Merger Waves 717
Bridge Loan 667 Types of Mergers 718
Common Loan Stipulations and Fees 667 22.2 Market Reaction to a Takeover 718
20.4 Short-Term Financing with Commercial 22.3 Reasons to Acquire 719
Paper 669 Economies of Scale and Scope 719
• Short-Term Financing and the Financial ­Crisis Vertical Integration 720
of the Fall of 2008 669 Expertise 720
20.5 Short-Term Financing with Secured Monopoly Gains 720
Financing 671 Efficiency Gains 721
Accounts Receivable as Collateral 671 Tax Savings from Operating Losses 721

A01_BERK7156_05_GE_FM.indd 14 20/01/22 5:37 PM

 Detailed Contents 15

Diversification 722 Hedging with Forward Contracts 752

Earnings Growth 723 Cash-and-Carry and the Pricing of Currency
Managerial Motives to Merge 724 Forwards 754
22.4 The Takeover Process 725 Hedging Exchange Rate Risk with
Valuation 725 Options 756
The Offer 726 23.3 Internationally Integrated Capital Markets 758
Merger “Arbitrage” 728 • COMMON MISTAKE Forgetting to Flip the
Tax and Accounting Issues 729 Exchange Rate 760
Board and Shareholder Approval 730 23.4 Valuation of Foreign Currency Cash Flows 760
22.5 Takeover Defenses 731 Application: Ityesi, Inc. 760
Poison Pills 731 The Law of One Price as a Robustness
Staggered Boards 732 Check 762
White Knights 733 23.5 Valuation and International Taxation 764
Golden Parachutes 733 The TCJA: A New Approach to International
Recapitalization 733 Taxation 764
Other Defensive Strategies 733
23.6 Internationally Segmented Capital
Regulatory Approval 734
Markets 765
• Weyerhaeuser’s Hostile Bid for Willamette Differential Access to Markets 765
Industries 734
Macro-Level Distortions 766
22.6 Who Gets the Value Added from a Implications of Internationally Segmented Capital
Takeover? 735 Markets 767
The Free Rider Problem 735
23.7 Capital Budgeting with Exchange Rate
Toeholds 736
Risk 768
The Leveraged Buyout 736
Application: Ityesi, Inc. 769
• The Leveraged Buyout of RJR-Nabisco by Conclusion 770
KKR 738
Summary 770 ● Critical ­Thinking 772 ●
The Freezeout Merger 739
Problems 773 ● Data Case 776
Competition 739
Summary 740 ● Critical Thinking 741 ●
Problems 742 Index 779

CHAPTER 23 International Corporate

Finance 745

23.1 Foreign Exchange 746

The Foreign Exchange Market 746
Exchange Rates 748
23.2 Exchange Rate Risk 748
Exchange Rate Fluctuations 749
• Brexit 750

A01_BERK7156_05_GE_FM.indd 15 20/01/22 5:37 PM

 About the Authors

Jonathan Berk is the A.P. Giannini Professor of

Finance at the Graduate School of Business, Stanford
University and is a Research Associate at the National
Bureau of Economic Research. Before coming to
Stanford, he was the Sylvan Coleman Professor of
Finance at Haas School of Business at the University
of California, Berkeley. Prior to earning his Ph.D., he
worked as an Associate at Goldman Sachs (where his
education in finance really began).
Professor Berk’s research interests in finance
include corporate valuation, capital structure, mutual
funds, asset pricing, experimental economics, and
labor economics. His work has won a number of
research awards including the Stephen A. Ross
Prize in Financial Economics, TIAA-CREF Paul A.
Jonathan Berk, Peter DeMarzo, and Jarrad Harford Samuelson Award, the Smith Breeden Prize, Best
Paper of the Year in The Review of Financial Studies,
and the FAME Research Prize. His paper, “A Critique of Size-Related Anomalies,” was
selected as one of the two best papers ever published in The Review of Financial Studies.
In recognition of his influence on the practice of finance he has received the Bernstein-
Fabozzi/Jacobs Levy Award, the Graham and Dodd Award of Excellence, and the Roger F.
Murray Prize. He served two terms as an Associate Editor of the Journal of Finance, and a
term as a director of the American Finance Association, the Western Finance Association,
and academic director of the Financial Management Association. He is a Fellow of the
Financial Management Association and a member of the advisory board of the Journal of
Portfolio Management.
Born in Johannesburg, South Africa, Professor Berk has two daughters, and is an avid
skier and biker.

Peter DeMarzo is the Staehelin Family Professor of Finance at the Graduate School
of Business, Stanford University and Faculty Director of the Stanford LEAD program. He
is past President and Fellow of the American Finance Association and a Research Associ-
ate at the National Bureau of Economic Research. He teaches MBA and Ph.D. courses in
Corporate Finance and Financial Modeling. In addition to his experience at the Stanford
Graduate School of Business, Professor DeMarzo has taught at the Haas School of Busi-
ness and the Kellogg Graduate School of Management, and he was a National Fellow at
the Hoover Institution.
Professor DeMarzo received the Sloan Teaching Excellence Award at Stanford and
the Earl F. Cheit Outstanding Teaching Award at U.C. Berkeley. Professor DeMarzo has
served as an Associate Editor for The Review of Financial Studies, Financial Manage-
ment, and the B.E. Journals in Economic Analysis and Policy, as well as President of the
Western Finance Association. Professor DeMarzo’s research is in the area of corporate
finance, asset securitization, and contracting, as well as market structure and regulation.
His recent work has examined issues of the optimal design of contracts and securities,
16

A01_BERK7156_05_GE_FM.indd 16 20/01/22 5:37 PM

 About the Authors 17

leverage dynamics and the role of bank capital regulation, and the influence of informa-
tion asymmetries on stock prices and corporate investment. He has also received nu-
merous awards including the Western Finance Association Corporate Finance Best-Paper
Award, the Charles River Associates Best-Paper Award, and the Barclays Global Investors/
Michael Brennan Best-Paper of the Year Award from The Review of Financial Studies.
Professor DeMarzo was born in Whitestone, New York, and is married with three boys.
He and his family enjoy hiking, biking, and skiing.

Jarrad Harford is the Paul Pigott-PACCAR Professor of Finance at the University

of Washington’s Foster School of Business. Prior to Washington, Professor Harford taught
at the University of Oregon. He received his Ph.D. in Finance with a minor in Organiza-
tions and Markets from the University of Rochester. Professor Harford has taught the
core undergraduate finance course, Business Finance, for over twenty years, as well as
an elective in Mergers and Acquisitions, and “Finance for Non-financial Executives” in
the ­executive education program. He has won numerous awards for his teaching, includ-
ing the UW Finance Professor of the Year (2010, 2012, 2016), Panhellenic/Interfraternity
Council Business Professor of the Year Award (2011, 2013), ISMBA Excellence in Teach-
ing Award (2006), and the Wells Fargo Faculty Award for Undergraduate Teaching (2005).
Professor Harford is currently a Managing Editor of the Journal of Financial and Quanti-
tative Analysis, and serves as an Associate Editor for the Journal of Financial Economics,
and the Journal of Corporate Finance. His main research interests are understanding
the dynamics of merger and acquisition activity as well as the interaction of corporate
cash management policy with governance, payout and global tax considerations. Professor
Harford was born in Pennsylvania, is married, and has two sons. He and his family enjoy
traveling, hiking, and skiing.

A01_BERK7156_05_GE_FM.indd 17 20/01/22 5:37 PM

 Bridging Theory
and Practice
EXAMPLE 7.1
Stock Prices and PROBLEM Study Aids with a Practical Focus
Suppose you expect Longs Drug Stores to pay an annual dividend of $0.56 per share in the coming year
Returns
and to trade for $45.50 per share at the end of the year. If investments with equivalent risk to Longs’ stock To be successful, students need to master the core
have an expected return of 6.80%, what is the most you would pay today for Longs’ stock? What dividend
yield and capital gain rate would you expect at this price? concepts and learn to identify and solve problems
SOLUTION that today’s practitioners face.
PLAN
We can use Eq. 7.1 to solve for the beginning price we would pay now 1P0 2 given our expectations about • The Valuation Principle is presented as the
dividends 1Div1 = $0.56 2 and future price 1P1 = $45.50 2 and the return we need to expect to earn to be
willing to invest 1rE = 0.068 2. We can then use Eq. 7.2 to calculate the dividend yield and capital gain rate. foundation of all financial decision making: The
EXECUTE central idea is that a firm should take projects or
Using Eq. 7.1, we have

Div1 + P1 $0.56 + $45.50

make investments that increase the value of the
P0 =
1 + rE
=
1.0680
= $43.13
firm. The tools of finance determine the impact
Referring to Eq. 7.2, we see that at this price, Longs’ dividend yield is Div1/P0 = 0.56/43.13 = 1.30%. of a project or investment on the firm’s value by
The expected capital gain is $45.50 - $43.13 = $2.37 per share, for a capital gain rate of
2.37/43.13 = 5.50%. comparing the costs and benefits in equivalent
EVALUATE
At a price of $43.13, Longs’ expected total return is 1.30% + 5.50% = 6.80%, which is equal to its
terms. The Valuation Principle is first introduced
equity cost of capital (the return being paid by investments with equivalent risk to Longs’). This amount is in Chapter 3, revisited in the part openers, and
the most we would be willing to pay for Longs’ stock. If we paid more, our expected return would be less
than 6.8% and we would rather invest elsewhere. integrated throughout the text.
PERSONAL FINANCE • Guided Problem Solutions (GPS) are Examples
PROBLEM
EXAMPLE 4.5 Ellen is 35 years old and she has decided it is time to plan seriously for her retirement. At the end of each that accompany every important concept using
Retirement Savings year until she is 65, she will save $10,000 in a retirement account. If the account earns 10% per year, how
Plan Annuity much will Ellen have in her account at age 65? a consistent problem-solving methodology that
SOLUTION breaks the solution process into three steps:
PLAN Plan, Execute, and Evaluate. This approach aids
As always, we begin with a timeline. In this case, it is helpful to keep track of both the dates and Ellen’s age:
35 36 37 65
student comprehension, enhances their ability
0 1 2
...
30 to model the solution process when tackling
+10,000 +10,000 +10,000 problems on their own, and demonstrates the
Ellen’s savings plan looks like an annuity of $10,000 per year for 30 years. (Hint : It is easy to become importance of interpreting the mathematical
confused when you just look at age, rather than at both dates and age. A common error is to think there
are only 65 - 36 = 29 payments. Writing down both dates and age avoids this problem.) solution.
To determine the amount Ellen will have in her account at age 65, we’ll need to compute the future
value of this annuity. • Personal Finance GPS Examples showcase the
EXECUTE
1
use of financial analysis in everyday life by set-
FV = $10,000 * 11.1030 - 1 2
0.10 ting problems in scenarios, such as purchasing a
= $10,000 * 164.49
new car or house and saving for retirement.
= $1.645 million at age 65
Using a financial calculator or Excel:

N I/Y PV PMT FV
Given:
Solve for:
30 10 0 210,000
1,644,940
• Common Mistake boxes alert students to
Excel Formula: 5FV(RATE,NPER, PMT, PV)5FV(0.10,30,210000,0) frequently made mistakes stemming from misun-
derstanding of core concepts and calculations—
EVALUATE
By investing $10,000 per year for 30 years (a total of $300,000) and earning interest on those investments, in the classroom and in the field.
the compounding will allow Ellen to retire with $1.645 million.

COMMON MISTAKE
Summing Cash Flows Across Time
Once you understand the time value of money, our first rule may seem straightforward. However,
it is very common, especially for those who have not studied finance, to violate this rule, simply
treating all cash flows as comparable regardless of when they are received. One example is in
sports contracts. In 2019, Mike Trout signed a contract extension with the Los Angeles Angels
that was repeatedly referred to as a “$430 million” contract. The $430 million comes from simply
adding up all the payments Trout would receive over the 12 years of the contract—treating dollars
received in 12 years the same as dollars received today. The same thing occurred when Lionel
Messi signed a contract extension with FC Barcelona in 2017, giving him a “$320 million” contract
through 2021, and in 2011 when Albert Pujols agreed to a “240 million” ten-year contract with the

18

A01_BERK7156_05_GE_FM.indd 18 20/01/22 5:37 PM

Another random document with
no related content on Scribd:
engaged in certain criminal enterprises with some leading spirits of
the underworld. Also he made no mention of the anonymous letter.
For the present he kept all this in reserve.
Needless to say that Richard was much astounded at these
revelations, especially at the fact of the imposture of young Archie
Brookes, with Mrs. Morrice’s connivance, and the loss of the
important memorandum relating to the safe.
“You have not told anything of this to Miss Sheldon,” was his first
comment. “Or, if you have done so, it would be under the seal of
secrecy, as otherwise she would have taken me into her confidence.”
“No, I have not said a word to Miss Sheldon,” was Lane’s answer.
“To tell you the truth, Mr. Croxton, in our profession we are not too
prone to make confidantes of women. We respect their good and
noble qualities, but we distrust their impulsiveness, their incapacity to
keep a secret where secrecy is of vital importance.”
Croxton was bound to agree with this general estimate. Women
were by temperament unfitted to be the coadjutors of men in
transactions of this special nature.
“Now, I have told you that Mr. Morrice asked me to allow him to be
joined in this investigation, and I consented because it did not seem
to prejudice your interests in any way, the aim of both being to
discover the guilty party. Now, it seems to me that the time has
arrived, or will very shortly be approaching, when it will be my painful
duty to inform him of his wife’s singular conduct in passing off this
young man, brought up by the woman Alma Buckley, as her nephew.
Before doing so, there is one contingency which we ought to
anticipate, although I consider it a very unlikely one. Is Mr. Morrice
himself a party to the deception? Is he already aware of it, and has
acquiesced in it from some motive satisfactory to himself? From your
close association with him, you must be well acquainted with his
character, his habits of thought, his views of what are right and
wrong. Do you think it likely that he would from any motives be a
consenting party to such a fraud?”
 And Richard’s answer was emphatic. Rupert Morrice was one of
the whitest men he had ever known, abhorrent of deceit and
chicanery in any form, high-minded and honourable to a fault, just a
little intolerant perhaps of weakness in others. Even in his business
life, his notions of rectitude were considered by those who knew him
best almost quixotic, and in private life his code of morality was just
as stringent. Even if he loved his wife with a passionate devotion, he
would never have tacitly suffered such a thing as this. And
everybody knew that while he treated Mrs. Morrice with the utmost
respect and consideration, ardent love played no part in their
relations. They made no pretence at being other than a very ordinary
couple who jogged along placidly enough.
After a little further conversation the interview terminated, leaving
the two men mutually pleased with each other. Lane thought that
Richard seemed a very straightforward, transparent sort of young
fellow with whom it was very difficult to associate a criminal
enterprise of such depth and cunning. And Dick recognized in the
detective a sound, solid man, with great gifts for his difficult task,
neither optimistic nor pessimistic, but holding the just mean between
the two extremes.
Lane was impressed by the shrewdness of the young man’s
remark when they parted. “If you can find who has got that
memorandum, you will discover the actual thief. I don’t believe in Mr.
Morrice’s theory of it having passed into the hands of the dustman.”
“Neither do I, Mr. Croxton. Well, good-bye for the present. I think
for the moment we will say nothing about these happenings to Miss
Sheldon. It is not because I wish to keep her in the dark, for I am
sure she is a good and noble girl. But for the moment, except to
those actually concerned, secrecy is imperative. A chance word, a
chance look, even a gesture might convey a warning where I do not
wish it to be conveyed. You understand.”
Yes, Richard thoroughly understood. He hated to keep anything
from his beloved Rosabelle, who had stood by him so staunchly in
these dark hours. But the detective was right, women cannot control
their feelings like men, especially where their deepest emotions are
concerned.
Lane had perhaps been more frank in his statement of the facts
than illuminating in his deductions from them, if indeed he had
suffered himself to draw from them any deductions of a very positive
nature. But the young man felt much more cheerful after that visit.
He felt quite sure that if the detective had started with suspicions of
him, he had dropped them by now, or his manner could not have
been so cordial. He was certain that was not assumed.
This keen and patient investigator had certainly made a series of
remarkable discoveries, it was almost impossible that nothing would
result from them. It was easy to see that he was not a man who
would tell you what was passing in his mind till the decisive moment
for revelation had come. No doubt, in his own quiet way, he was
drawing his net tighter and tighter. Would he draw it so closely at the
end that the real criminal could not escape from its meshes? And
would he, Richard Croxton, be rehabilitated in the sight of all men?
Would the day come when Rupert Morrice would ask his pardon for
his unjust suspicions, his harsh treatment, for having branded the
son of his old sweetheart as a thief?
On his return from Petersham to his office, Lane found Sellars
waiting for him by appointment. To this keen-witted young man he
detailed the three fresh incidents that had occurred in so short a
space—the conversation between Mrs. Morrice and her supposed
nephew, overheard by Rosabelle; the fact that Sir George was under
the close observation of Scotland Yard, the further startling fact that
Archie Brookes had been brought up in the home of Alma Buckley.
He wound up with the information that he had dispatched an
anonymous letter to Rupert Morrice, the contents of which he trusted
would induce the financier to start a searching investigation on his
own account.
“By Jove, that was a fine idea, Lane, and got you out of an
awkward situation,” said Sellars in a tone of admiration. “If he finds
what, no doubt, we expect him to find, there will be trouble in
Deanery Street. For, although I can’t pretend to know very much
about him, he strikes me as just the kind of man who could be as
hard as nails in certain circumstances.”
“Yes, I should say it was so,” Lane agreed. “Young Croxton, with
whom I had a long talk to-day, tells me that he is the soul of honour
and rectitude, that he has no toleration of wrong-doing in others,
being so exempt from weaknesses himself. He gives me that
impression too—the sort of man who would sacrifice his own son if
he thought justice demanded it.”
Sellars had no petty jealousy of the other man’s superior powers in
the line in which Lane was a master, and he, comparatively
speaking, only a promising pupil. But he did occasionally fancy that
he could see a point which the master, perhaps through
carelessness, had overlooked. He thought he saw one now.
“That’s not quite true, is it? He firmly believed in young Croxton’s
guilt, believes in it still from what you have told me. But he didn’t
prosecute him. Not quite such a hard nut as we think him, perhaps.”
But Lane was not to be worsted in argument by his nimble-minded
young pupil. “I didn’t say he was out for revenge, only for justice. He
satisfied justice by turning him out of the house and ruining his
career. And he did that in spite of the fact that he passionately loved
the mother.”
“Yes, I see your point. Perhaps he may shield his wife in the same
way, or rather a different way, keep up the appearance of a happy
couple in public, and treat her as a stranger in private. Well, the next
important move on the board is the meeting with Miss Buckley—that
information you have just got ought to give me a point in the game,
anyway.”
 CHAPTER XVIII
MRS. MORRICE’S DRESS

W HEN Rupert Morrice received that anonymous letter, which

arrived by the last post of the day on which it had been
dropped in a City pillar box, and was brought to him in his study, his
first impulse was to throw it in the fire. Like all men in prominent
positions, whose success in life is bound to raise up enemies, he
had in his time received many of these waspish and stinging
epistles.
But on second thoughts he resolved that he would reflect a little
before he finally dismissed it from his mind. It was a very brief
epistle, but it contained a most definite suggestion. And something in
the exceedingly positive wording of it conveyed the impression that
the anonymous writer knew a good deal of what was going on in the
financier’s household.
“Sir,—You are a man of such scrupulous integrity
yourself, that you are apt to believe all those associated
with you are possessed of similar high-mindedness. The
last thing a prudent man should do is to put a blind trust in
those of his own household, for it will be in these that he
will most often be bitterly disappointed. I have reason to
know that Mrs. Morrice has for a long time past been
spending large sums of money in a certain direction,
which could not possibly be defrayed out of your
allowance to her, generous as it is. I would advise you to
make an inspection of the costly jewels you have given
her, and satisfy yourself that they have not been tampered
with. If my suspicions turn out to be wrong, I shall much
regret having disturbed you and suspected an innocent
woman. But I think it my duty to tell you what I know.
“A Well-Wisher.”
 There was, of course, no clue to the identity of the writer, the
ingenious author of this very plain-spoken epistle had seen to that.
The envelope was one of a common make and pattern, it bore a
certain City postmark, like thousands of other letters posted at the
same time in the same neighbourhood; the paper was a sheet torn
from one of the thousands of letter-pads in common use. It did not
even possess the slight clue of a water-mark.
Morrice thought that even the astute Lane himself would never be
able to trace it to its sender, if he were to take it to him. But, of
course, he had no intention of doing this. He was a very reticent man
in all things appertaining to his private affairs, and a slur cast upon
the woman who bore his name was an affront to himself.
It is possible that in ordinary circumstances he would have
dismissed the matter from his mind, deeming it the work of some
hidden enemy who, in his desire to annoy him, had chosen this way
of wounding him in his tenderest relations; for if he was not deeply in
love with his wife, as he had been with Richard Croxton’s mother, he
was fond of her in a calm, steadfast way, he was proud of her social
qualities, he was grateful to her for her ready obedience to all his
wishes.
But recent events had rendered him very distrustful and
suspicious; and the wording of the letter was very positive. One of
the sentences in it was strangely significant: “I have reason to know
that Mrs. Morrice has for a long time past been spending large sums
of money in a certain direction.” He was advised to examine the
costly jewels he had given her with a view to seeing that they had
not been tampered with.
It would seem, assuming that there was any truth in the innuendos
it contained, that it must be written by somebody who had an
intimate knowledge of Mrs. Morrice. For a moment it flashed across
him that from motives of revenge Richard Croxton had written it to
stir up strife between the husband and wife. It could not be
Rosabelle, she was too fond of her aunt, and besides, if she wanted
to do her an injury, he was certain the girl was too high-minded to
make use of such a shameful weapon as an anonymous letter.
Probably it might have come from a discharged servant who chose
this method of wreaking his or her spite.
But Morrice could not remember that any servant had been
discharged for several years past. It was such a comfortable service
that those who entered it stayed till natural circumstances brought
about a severance of the relations.
Ought he not to show it to his wife, and accept the denial of the
accusation which she would be sure to make? Had he not been
rendered doubting and embittered by these recent happenings, that
is just what he would have done. But the discovery of Richard
Croxton’s unworthiness, for he still believed in his guilt, in spite of the
doubting attitude of Lane, had rendered him morbidly suspicious of
everybody, with perhaps the single exception of Rosabelle.
And yet, and yet, it could not be true. It would be absurd to pretend
that their marriage had been one of ardent or romantic affection;
neither of them had made any pretence of such to the other. He was
tired of celibacy, he wanted somebody to be the mistress of his
home, possibly to give him an heir. She, on her side, was quite
naturally attracted by his wealth, by the position he could give her.
But because a woman is swayed in her choice by worldly
advantages, it does not follow that she is a person of dishonourable
impulses.
After a good deal of rather perturbing reflection, he came to the
conclusion with regard to this letter that, while he would not attach
undue importance to it, he would not definitely ignore it. And certainly
he would not follow what a few months ago would have seemed a
natural impulse, go to her and show her the letter, and say in his
blunt, straightforward way: “You see what it suggests. Is it a lie or a
truth?”
He happened at this time to be very busy on one of those big
financial schemes which had made his house so famous, and
although at no particular moment was the incident entirely removed
from his mind, it was greatly overshadowed by the almost incessant
calls upon his time and thoughts in connection with this huge foreign
loan. He thought of it, as it were, only to put it aside to a more
convenient season.
A trifling incident brought it back to his recollection in full force.
They were attending a big function at a certain ducal house to which
all the élite of London had been invited. At such an important
gathering every woman would naturally wish to appear her best, to
wear her smartest clothes, to don her most valuable jewellery. Mrs.
Morrice was as proud of her appearance as most women, she would
certainly not wish to be outshone by her neighbours.
For some days past the two women had talked of this function,
had discussed who was likely to be invited and as likely excluded,
and settled what they were going to wear. Rosabelle had ordered a
new frock for the occasion and was much surprised that her aunt
had not done the same, but was going in one that had already done
her good service.
This entertainment was fixed to take place a few days after she
had overheard that suspicious conversation in the boudoir. The girl
thought she understood now the reason of her aunt’s economy, not
only on this particular occasion but for a long time past. The money
which would have gone to her dressmaker in the ordinary course
had been diverted in the direction of Archie Brookes, to pay his
pressing debts, to enable him to avert disgrace for the time being.
Rosabelle thought it rather a pity her aunt should not have made
some special effort for such a unique affair; she thought she owed it
to her husband to maintain her position in a proper manner. Still, if
she was not going to assume any striking raiment, she would
certainly put on the most magnificent of her jewels, and these, no
doubt, would carry her through.
There was one very valuable pearl necklace which she was wont
to assume at magnificent functions like the present ducal reception,
and in a conversation the day before it took place, Rosabelle
carelessly remarked to her aunt that she supposed she would wear it
when the evening arrived.
 Mrs. Morrice had appeared to hesitate before she answered.
When she did, she spoke in an indifferent tone, and, to the girl’s
quick ears, it seemed that the indifference was assumed.
“I suppose I shall, my dear, but I haven’t really made up my mind,
probably shan’t do so till the last minute. I might put on something a
bit newer. I have worn it so often, everybody who knows me has
seen it dozens of times.”
A painful thought crossed Rosabelle’s mind and gave her an
inward shiver, but on reflection she dismissed it. Her aunt’s fondness
for her nephew might lead her to stint herself in many ways to enable
her to minister to his extravagances, but surely she would not go to
any desperate lengths.
But that hesitation, the assumed indifference of her manner, were
very strange. This particular necklace was far and away the most
exquisite and costly thing in her collection, which was pretty
extensive. She had other necklaces of varying value, but nothing that
was so suitable to such an important occasion.
Mrs. Morrice was the last to come down, the other two had been
ready for some little time and were waiting for her in the hall. To the
girl’s surprise, she wore a necklace of considerable value, but only
about half that of the gem of the collection. Again Rosabelle felt that
curious sensation that there was some hidden significance in the
fact.
Morrice was not, as a rule, very observant of woman’s dress. But
to-night, for some reason or another, he seemed to scrutinize his
wife very keenly. His eyes travelled over her frock till they reached
the comparatively modest article of jewellery. Then he spoke:
“This is not a new dress for the occasion, is it?”
Mrs. Morrice answered in a low voice that it was not, that she had
worn it once before and that she thought it suited her extremely well.
This was a falsehood, for Rosabelle had seen her aunt in it half a
dozen times.
“I thought I recognized it,” was her uncle’s comment, and the girl
thought there was a rather hard inflexion in his voice, as if he were
not too well pleased. He touched the necklace lightly with his finger.
“This doesn’t seem quite good enough for such a grand occasion.
Why didn’t you put on the big birthday one?” He always called it this
because it had been one of his birthday presents to her.
His wife gave much the same answer that she had given to
Rosabelle. She had worn it so often, everybody knew it. She was
getting just a little bit tired of it herself, and would give it a rest for a
little time.
Rosabelle, watching her uncle keenly, saw a hard look come over
his face, a look which she knew denoted displeasure not unmixed
with suspicion. What could have caused it? Was it possible he
suspected anything? Of course, she knew nothing of the anonymous
letter. He said no more, however, and the small party trooped out to
the waiting car.
But something in his wife’s manner had not satisfied him, and he
was now on the watch. Two days after, husband and wife were to
attend a big dinner-party. In the afternoon when he came home he
went into Mrs. Morrice’s boudoir, where she and Rosabelle were
sitting together.
“Oh, Lettice, I only just wanted to say I wish you particularly to
wear the ‘birthday’ pearls to-night.”
Rosabelle looked up, just a little startled. His tone was not quite so
hard as it had been the other night, but it was certainly not his
ordinary one.
She turned her glance rather anxiously to her aunt. But Mrs.
Morrice seemed perfectly at her ease, as she answered: “Certainly,
Rupert, if you wish it, although I think they are just a little
overpowering for to-night.”
So she came down in the “birthday” pearls when it was time to
start and Rosabelle, who did not accompany them, was very
relieved. Whatever suspicions her uncle had formed, he would be
free of them now.
 But that was just what Morrice was not. Subtly influenced by the
anonymous letter, he thought he had noticed an evasiveness in his
wife’s manner on the night of the ducal entertainment when she had
given her reasons for not wearing her most valuable necklace.
There was only one way in which he could be satisfied, and that
way he was going to take as soon as he could find an opportunity.
When he once took a thing in hand, he never rested till he got to the
bottom of it, being of a determined, not to say a dogged nature.
The opportunity came one morning when Mrs. Morrice started
early to lunch with an old friend, living some forty miles out of
London. Her maid had been given a holiday till five o’clock, the hour
at which her mistress proposed to return, for she was a very kind
and considerate employer and frequently showed these small
kindnesses to her servants. The coast was clear.
He went upstairs to her dressing-room. The more valuable articles
were kept in a safe which had once been used by him, and of which
he possessed a duplicate key, unknown to his wife.
Quickly he took the pearl necklace in its case, and put it in a small
bag which he had brought up with him for the purpose, then went
downstairs, feeling in his honest and upright heart, rather like a thief
himself. But, as a matter of fact, he could not rest till he had
convincingly tested the truth of that anonymous letter.
He hailed a taxi and drove to a shop, a high-class jeweller and
gem-merchant in the neighbourhood of St. James’s to whom he was
not known personally as he was at so many Bond Street
establishments. He asked to see the proprietor in his private room
and asked him his fee for giving him his opinion on what was
supposed to be a very fine pearl necklace.
In a very short time he was in possession of the information he
sought. The pearls were pronounced to be splendid imitations, likely
to deceive anybody except an expert, but worth as many shillings as
the original necklace had cost pounds.
His face set like a grim mask, he returned to Deanery Street and
replaced the sham gems in the safe. The anonymous letter had told
the truth, the writer of it had evidently known what had been going on
in his household.
 CHAPTER XIX
MISS ALMA BUCKLEY

M ISS ALMA BUCKLEY did not seem at all anxious for that
interview so desired by young Sellars. He had written her a
very polite letter, forwarded by her obliging agent, stating that he
wished to see her for a few minutes on a private matter which it was
difficult to enter into by correspondence, and inviting her to name a
day and hour suitable to herself. He had found out that she was
appearing nightly at certain suburban music-halls, and judged from
this fact that she would appoint a morning or an afternoon.
He waited three days for an answer, but as none came, he
dispatched a second missive expressing his fear that his first had
miscarried, and begging the favour of a reply by return.
By return it came, a very brief and curt note but well-expressed,
written in the third person. “Miss Buckley has to acknowledge the
receipt of two letters from Mr. Sellars, asking for an interview on a
private matter. She has no knowledge of the writer, and before
granting his request, would like to know the nature of the business
on which he is desirous of seeing her.”
Obviously not an ill-educated person to whom the use of the third
person would have presented numerous pitfalls. Sellars did not relish
the tone of her letter at all, and did not quite know how to proceed.
He could probably gain admittance by pretending he was engaged in
some professional enterprise in which he would be glad of her co-
operation. But he would have to abandon that attitude when he got
there, and most certainly arouse her resentment by admitting that it
was a trick to enable him to steal a march upon her. He would then,
in all probability, be unceremoniously bundled out.
Miss Buckley dated her letter from No. 5 Elvenden Mansions, Kew
Bridge, evidently a block of flats. He thought the best way would be
to take direct action by calling there without preliminary
announcement, trusting to luck to find the lady at home and willing to
admit him. He arrived there about twelve o’clock on the morning of
the day after that on which he had received her somewhat brusque
letter.
He thought this would be a judicious hour. Professional ladies he
had always understood were not early risers, they preferred the day
to be well-aired before they got up. In the afternoon they probably
rested to prepare themselves for the arduous duties of the evening.
He found the place quite easily—a very extensive block of flats of
respectable appearance, the rentals of which he thought would be
neither cheap nor expensive, just suitable to persons of moderate
means.
Miss Buckley opened the door herself, it was very likely she did
not keep a resident servant. She was a comely, good-looking woman
of an unrefined type, looking much younger than her years, which
Sellars, piecing together the information he had gathered at
Brinkstone, put in the region of fifty. She had a very brilliant
complexion, obviously the result of very careful art. She was a trifle
inclined to stoutness, but not by any means unbecomingly so, and
she had a very pleasant expression. Perhaps she was only brusque
when she took a pen in her hand.
As she surveyed him, taking in every detail of his immaculate get
up and elegant appearance, a twinkle appeared in her rather bold,
blue eyes, and she smiled broadly.
“I don’t think you need tell me who you are,” she said in a jolly,
rather loud voice. “I’ll lay five to one to anybody who likes to take me
on that you’re Mr. Sellars.”
This was quite a breezy reception, better than the young man had
hoped for. Miss Buckley was evidently not a mincing person nor
inclined to finnicking speech.
Sellars made his best bow, removing his hat with a grace
peculiarly his own. “I compliment you on your penetration, Miss
Buckley, you have guessed at once. I ran up here on the chance of
finding you in, as I am leaving London very shortly, and I didn’t want
to waste time in needless correspondence. Now that I am here, I
hope you won’t be so cruel as to turn me away.”
The music-hall artist looked at him not unkindly, he was a very
personable young fellow, and possessed charming manners.
She opened the door a little wider. “Well, I suppose I ought to send
you to the right about, but then you’d only pester me with more of
your polite letters. So come in, and let me know what it is you want
of me.”
She led the way into a very daintily-furnished little sitting-room, the
greater portion of which was taken up with a semi-grand piano on
which she, no doubt, practised the vivacious songs that found favour
with her public. A cheerful fire burned in the grate. A fair sized round
table stood in the centre, and on this was a good sized cake and a
decanter of port wine.
“I couldn’t make much of a show at breakfast this morning,” she
explained candidly to her visitor. “Some of us were keeping it up a bit
last night late. So I’m just picking a little bit now, as I don’t have my
meal till five. The profession’s very awkward for meals. Now before
you start, Mr. Sellars, try a glass of this port. I’ve had one and I’m
going to have another—doctor’s orders, you know.” She laughed her
loud, genial laugh, and again the twinkle came into the big, blue
eyes.
Sellars hastened to get on friendly terms with her by cheerfully
accepting her hospitality, and found the port very excellent. It was
evident that Miss Buckley, although a very small light of the
profession, was by no means forced to practise rigid economy. All
the furniture was elegant and costly. A handsome bronze clock and
candelabra adorned the mantelshelf, which was hung with elegant
rose-pink drapery. In a word, her surroundings were much more
refined than herself.
Yes, there was no doubt she was very comfortably off. And there
was every reason she should be, he reflected. The retired builder,
her father, must have had a decent income which, no doubt, he had
left entirely to her, she was hardly ever out of an engagement, so his
club acquaintance had told him, and she would get a decent salary
from her profession, even if she was only a star of small magnitude.
When they had drunk to each other’s health, for the lady insisted
upon this ceremony being observed, Miss Buckley came to
business, speaking in a brisk tone that rather suggested the writer of
the brusque letter.
“And now, Mr. Sellars, please tell me the reason that has brought
you into this remote part of the world. Judging by what I’ve seen of
you so far, I should say you were more likely to be found in Bond
Street and Piccadilly than the wilds of Kew.”
While they had been drinking their port and chatting discursively,
the keen eyes of Sellars had been taking in the details of the dainty
little apartment. Most particularly had he directed his attention to the
half-dozen photographs on the rose-pink covered mantelpiece. Two
of them he recognized at once as those of Sir George Clayton-
Brookes and young Archie Brookes. A third was that of a young girl
of about eighteen or nineteen years of age, in which he thought he
could trace some resemblance to the present handsome and
dignified Mrs. Morrice. Ah, if only his old friend Dobbs were here he
could have told him at once. One thing was very evident, there was
no portrait of the Mrs. Morrice of the present day amongst the
collection.
After putting her question, Mrs. Buckley looked at the young man
very keenly while awaiting his reply. He did not answer at once, but
rose from his chair, walked to the mantelpiece, took a leisurely
survey of the photographs and then turned to the music-hall artist.
“I see you have the likenesses of two men I know a little of, Miss
Buckley, Sir George Clayton-Brookes and his nephew. I should say
your memories must often carry you back to the old days in the little
village of Brinkstone.”
In spite of the self-possession engendered by so many years of
facing big audiences, the woman could not help giving a start of
surprise which did not escape the keen eyes of Sellars.
 “What in the world do you know about Brinkstone?” she asked in a
hard voice. Her jollity had gone for the moment, she was the sharp,
alert woman of the world, ready to keep a close watch on her words,
more disposed to ask questions than answer them.
Sellars left the mantelpiece and sat himself on the chair opposite
her, putting on a very ingenuous expression of countenance.
“I know rather a lot,” he said pleasantly. “Shortly before Christmas
I took a fancy to run down there, and I put in a few very agreeable
days. I was engaged on some literary work, and I found it very quiet
and peaceful. There I made the acquaintance of a very delightful old-
world sort of fellow who had seldom stirred beyond the confines of
his native village—the head waiter, as he is now, one Dobbs. I am
sure you can’t have forgotten dear old Dobbs, Miss Buckley?”
The lady breathed a little hard. He guessed that she had half a
mind to tell a lie, disclaim all knowledge of the little village of
Brinkstone and its inhabitants, but she was afraid to because she
was not sure how much he knew.
“Perhaps I have, perhaps I haven’t. And how does it concern you,
Mr. Sellars, whether I know him or not?”
But Sellars did not answer her question, he put one himself.
“The portrait of that very pretty girl—am I not right in saying it is
one of your girl friend—Lettice Larchester?”
Again he saw that she was strongly tempted to tell a lie, to give
him another name as the original of that charming picture, and that
she refrained for the same reason.
“You seem to know all my friends, apparently. Can you tell me the
other three?” she inquired in a voice of heavy sarcasm.
“I am afraid I cannot, they do not interest me in the least,” he said
easily. “Well, to resume about good old Dobbs. In the evenings when
he was clearing the dinner things, we used to have long chats
together, a drop of whisky set his tongue going nineteen to the
dozen, and he told me lots of things about Brinkstone people.”
 “Must have been very interesting, I’m sure,” said the lady, with
something like a snort. She helped herself to another glass of port,
but did not offer one to Sellars.
“It was extremely interesting,” agreed Sellars in his calm, placid
way. “I don’t know when I ever listened to a more delightful recital of
village annals. I heard all about the rather lurid doings of that
remarkable family, the Brookeses, the father and the three brothers
of whom Sir George is now the sole survivor. And equally absorbing,
the history of Miss Larchester and her derelict father, and last the
story of your arrival at Brinkstone and your subsequent friendship
with the young lady in question. Old Dobbs had a great tenderness
for her, he used to grow quite lyrical in his descriptions.”
“You went down there, of course, to spy out all this,” remarked
Miss Buckley in contemptuous tones. “I take it you are really a
detective, although I must say you haven’t got the cut of one. Well,
Mr. Sellars, what is it you want with me? Please come to the point.”
“I am not exactly a detective, not professionally I mean, only just a
rather curious person. I am very anxious to know something of the
career of your pretty friend Miss Larchester, after she left the little
village.”
And then Miss Buckley spoke. It was evident she had been
thinking pretty quickly while the young man was talking, and had
made up her mind what sort of a story she was going to tell.
“I have known Sir George on and off since the Brinkstone days, he
mixes a good deal with artists; I knew his nephew through him when
he brought him over from Australia and adopted him. I met Lettice
Larchester a few times in London—they seemed to be getting poorer
and poorer. Then suddenly they drifted away and I never heard any
more of her.”
Sellars was silent for a long time. “Then it comes to this,” he said
presently, “you won’t tell me anything of your old friend.”
“I have nothing to tell,” said the woman obstinately.
“You do not know whether she is dead or alive?” persisted Sellars.
“And if alive, whether she is married or single.”
 Again the same obstinate answer. “I know nothing, and now, Mr.
Sellars, I think it is time to end this interview.”
The young man was chagrined at the negative result of his visit.
The only thing he was certain of was that Mrs. Morrice had certain
secrets in her past life which this woman was resolved to guard
jealously. Also she had told a deliberate lie about Archie Brookes in
saying that her acquaintance with him had dated from his arrival
from Australia.
“I will trouble you no more on that subject, Miss Buckley. Are you
disposed to be more frank with me on the subject of Archie
Brookes?”
She shrugged her shoulders impatiently. “My good man, will you
have the kindness to go. I know hardly anything of him except that
he is Sir George’s nephew and came over here a few years ago from
Australia.”
Sellars looked her straight in the face. “And that, pardon me for my
rudeness, is not a fact. When Sir George adopted him, he took him
from your home, and at that time he was occupying a commercial
post in the City.”
And this time the shaft went home. The woman dropped her eyes,
and a tell-tale flush spread above the rouge on her painted cheek.
But she recovered herself quickly, walked to the door and flung it
open. “For the second and last time, Mr. Sellars, I request you to
bring this interview to a close.”
He moved after her, speaking as he went. “I am sorry our
acquaintance ends so abruptly. One last word—if a certain person
would give you a handsome sum to disclose what you do know
about these two people, would you be induced to speak?”
And for the last time came the defiant answer: “I should be taking
your money under false pretences. I have no information to sell.”
 CHAPTER XX
RUPERT MORRICE SENDS FOR LANE

L ANE was as chagrined as Sellars himself when he learned the

result of that interview with Alma Buckley, for he had rather
pinned his hopes on it. The great majority of people who engaged in
wrong-doing were corruptible, as he had found by long experience.
This middle-aged music-hall artist was a striking exception.
“Drawn into crooked paths by accident perhaps,” he commented,
“and makes loyalty to her pals her first principle or, equally probable,
is too well paid by the other side to consider it worth while treating
with us.”
He rose and paced the room, a sign with him of unusual mental
activity. “Well, now, it is needless to say, I am very grievously
disappointed, I looked for some good results, and the worst of it is,
we have given ourselves away. In another twenty-four hours our
friend the baronet and Mrs. Morrice will know of your visit, and will be
on their guard.”
Sellars agreed. “That is inevitable. Unless she happened to speak
the truth when she said that she knew nothing of Mrs. Morrice and
did not know whether she was dead or alive.”
“That’s a lie like the other about Archie Brookes,” replied the
detective grimly. “I don’t think I’ve told you before, but I have had
Mrs. Morrice under observation by one of my best men for a little
time. During that period she has paid two visits to the Kew flat. Alma
Buckley is a useful friend in many ways, although she is not an
official one and doesn’t show up at Deanery Street—and no doubt,
she gets well paid for her services. It won’t be very long now before
we shall have to open the eyes of the master of the house.”
He was pacing up and down the room with very vigorous strides
now, his physical energy reflecting his mental activity. In that keen