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

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 Fundamentals of
Corporate Finance
Eleventh EDITION

Richard A. Brealey
London Business School

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

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

FUNDAMENTALS OF CORPORATE FINANCE

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Dedication To Our Families
 About The Authors

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

Courtesy of Richard A. Brealey

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

Courtesy of Stewart C. Myers

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

Courtesy of Alan J. Marcus

vi
Preface

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

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

Fundamentals and Principles of Corporate Finance

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

vii
viii Preface

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

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

Organizational Design
Fundamentals is organized in eight parts.

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

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

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

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

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

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

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

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

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

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

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

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

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

Routes through the Book

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

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

Changes in the Eleventh Edition

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

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

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

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

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

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

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

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

Specific Chapter Changes in the Eleventh Edition

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

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

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

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

Confirming Pages

Spreadsheet Solutions Boxes

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

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

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

Excel Exhibits 10 Coupon payments

per year
1 2 1

Selected exhibits are set as Excel 11

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

files are available for instructors

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

FIGURE 6.6 How bond prices

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

1,000

900

800 Price path for the 2%

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

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

Financial Calculator Boxes

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

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

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

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

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

Marlena Akhbari Shelley Canterbury Brian E. Young Phillip Giles

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

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

xxi
Tom Strickland Michael Toyne Qiang Wu Athena Zhang
Middle Tennessee State Northeastern State Rensselaer Polytechnic California State
University University University University–Chico
Jan Strockis James Turner Patricia Wynn Shaorong Zhang
Santa Clara University Weber State University University of North Texas Marshall University
at Dallas
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California State University University of Mississippi David Yamoah University of North Dakota
Fullerton Kean University
J. Douglas Van Ness Yiling Zhang
Joseph Tanimura Columbia University Fred Yeager University of Texas–
San Diego State University St. Louis University Arlington
Joe Walker
Steve Tokar University of Woongsun Yoo Zhong-Guo Zhou
University of Indianapolis Alabama–Birmingham Saginaw Valley State California State
University University–Northridge
Damir Tokic Kenneth Washer
University of Texas A&M Kevin Yost Zi Jia
Houston–Downtown University–Commerce Auburn University University of Arkansas at
Kudret Topyan Little Rock
K. Matthew Wong Emilio R. Zarruk
Manhattan College St. John’s University Florida Atlantic University

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

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

xxii
Contents in Brief

Part One 1 Goals and Governance of the Corporation 2

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

Part Two 5 The Time Value of Money 118

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

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

Part Four 14 Introduction to Corporate Financing 420

Financing 15 How Corporations Raise Venture Capital and Issue Securities 440

Part Five 16 Debt Policy 466

Debt and Payout 17 Payout Policy 504
Policy

Part Six 18 Long-Term Financial Planning 526

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

Part Seven 21 Mergers, Acquisitions, and Corporate Control 610

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

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

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

xxiii
 Contents

Part One Introduction

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

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

The Stock Market 37 4.5 Analyzing the Return on Assets:

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

Transporting Cash across Time 45 4.8 Interpreting Financial Ratios 104

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

Summary 51
Questions and Problems 52

xxv
xxvi Contents

Part Two Value

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

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

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

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

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

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

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

Real versus Nominal Cash Flows 147 Bubbles and Market Efficiency 222

Inflation and Interest Rates 149 Behavioral Finance 223

Valuing Real Cash Payments 151 Summary 224

Real or Nominal? 152 Questions and Problems 225

Summary 152 Minicase 232

Questions and Problems 153

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

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

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

9.2 Corporate Income Taxes 279 Summary 320

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

Part Three Risk

Chapter 11 11.5 Thinking about Risk 351

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

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

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

Part Four Financing

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

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

Ownership of the Corporation 427 Other New-Issue Procedures 449

Voting Procedures 428 The Underwriters 450

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

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

Part Five Debt and Payout Policy

Chapter 16 Minicase 499

Debt Policy 466 Appendix: Bankruptcy Procedures 501

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

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

Summary 491
Questions and Problems 492

Part Six Financial Analysis and Planning

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

Summary 541 Summary 563

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

Chapter 20 Other Payment Systems 591

Working Capital Management 570 Electronic Funds Transfer 592

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

Collection Policy 584 Commercial Paper 598

20.3 Inventory Management 586 Summary 599

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

Part Seven Special Topics

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

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

Avoiding Fudge Factors 655 Chapter 24

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

Summary 682
Questions and Problems 683

Part Eight Conclusion

Chapter 25 Are There Important Exceptions to the

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

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

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

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

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

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

Agency Theory 716 Questions and Problems 721

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

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

Goals and
1 Governance of
the Corporation

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

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

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

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

1.1 Investment and Financing Decisions

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

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

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

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

Company Recent Investment Decisions Recent Financing Decisions

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

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

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

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

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

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

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

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

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

Other Forms of Business Organization

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

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

1.4 Goals of the Corporation

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

Example 1.2 ⊲ Value Maximization

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

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

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

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

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

FIGURE 1.3 The firm can

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

Invest Alternative: Shareholders

pay out cash invest for
to shareholders themselves

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

7
We have mentioned 5% or 20% as possible future rates of return on Tesla’s project. We will see in Chapter 8
that future rates of return are sometimes difficult to calculate and interpret. The general principle always holds,
however. In Chapters 8 and 9 we show you how to apply the principle by calculating the net present value
(NPV) of investment projects.
Another random document with
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so as to embrace the whole scheme of the universe, I should no
longer perceive the contents of that universe as dispersed through
space, because I should no longer have as my special standpoint a
here to which other existence would be there.
My special standpoint in space may thus be said to be
phenomenal of my special and peculiar interests in life, the special
logical standpoint from which my experience reflects the ultimate
structure of the Absolute. And so, generally, though the conclusion
can for various reasons not be pressed in respect of every detail of
spatial appearance, the spatial grouping of intelligent purposive
beings is phenomenal of their inner logical affinity of interest and
purpose. Groups of such beings, closely associated together in
space, are commonly also associated in their peculiar interests, their
special purposes, their characteristic attitude towards the universe.
The local contiguity of the members of the group is but an “outward
and visible sign” of an “inward and spiritual” community of social
aspiration. This is, of course, only approximately the case; the less
the extent to which any section of mankind have succeeded in
actively controlling the physical order for the realisation of their own
purposes, the more nearly is it the truth that spatial remoteness and
inner dissimilarity of social purposes coincide. In proportion as man’s
conquest over his non-human environment becomes complete, he
devises for himself means to retain the inner unity of social aims and
interests in spite of spatial separation. But this only shows once
more how completely the spatial order is a mere imperfect
appearance which only confusedly adumbrates the nature of the
higher Reality behind it. Thus we may say that the “abolition of
distance” effected by science and civilisation is, as it were, a
practical vindication of our metaphysical doctrine of the comparative
unreality of space.
Similarly with time, though the temporal series may, in a sense, be
said to be less of an unreality than the spatial. For it does not seem
possible to show that spatial appearance is an inevitable form of
finite experience. We can at least conceive of a finite experience
composed entirely of successive arrangements of secondary
qualities, such as sounds or smells, and the accompanying feeling-
tones, though we have no positive ground for affirming the existence
of such a type of experience. But the temporal form seems
inseparable from finite intelligence. For the limitation of my existence
to a certain portion of time is clearly simply the abstract and external
aspect of the fact that my interests and purposes, so far as I can
apprehend the meaning of my own life, occupy just this special place
in the logical development of the larger whole of social life and
purpose of which my own life is a member. So the position of a
particular purposive act in the temporal series of acts which I call the
history of my own life, is the outward indication of the logical place
filled by this particular act in the connected scheme of interests
which form my life on its inner side. But it is an inevitable
consequence of the want of complete internal harmony we call
finitude, that the aims and interests of the finite subject cannot be in
the same degree present to its apprehension all at once and
together. In being aware of its own internal purpose or meaning, it
must, because it is finite and therefore not ultimately a completely
harmonious systematic whole, be aware of that purpose as only
partially fulfilled. And in this sense of one’s own purposes as only
partially fulfilled, we have the foundation of the time-experience, with
its contrast between the “now” of fulfilment and the “no longer” and
“not yet” of dissatisfied aspiration.
For this reason, dissatisfaction, unfulfilled craving, and the time-
experience seem to be bound up together, and time to be merely the
abstract expression of the yearning of the finite individual for a
systematic realisation of its own purpose which lies for ever beyond
its reach as finite. If this is so, only the absolute and infinite individual
whose experience is throughout that of perfectly harmonious
systematic realisation of meaning, can be outside the time-process;
to it, “vanished and present are the same,” because its whole nature
is once for all perfectly expressed in the detail of existence. But the
finite, just because its very nature as finite is to aspire to a perfection
which is out of reach, must have its experience marked with the
distinction of now from by and by, of desire from performance. In this
temporal character of all finite experience we may perhaps
afterwards discern the ultimate ground of morality, as we can already
discern in the unresting struggle of the finite to overcome its finitude,
practical evidence that time is not a form which adequately
expresses the nature of Reality, and must therefore be imperfect
appearance.[154]
Thus we seem finally to have reached the conclusion that time and
space are the imperfect phenomenal manifestation of the logical
relations between the purposes of finite individuals standing in social
relations to each other; the inner purposive life of each of these
individuals being itself in its turn, as we have previously seen, the
imperfect expression, from a special logical “point of view,” of the
structure and life of the ultimate infinite individual. For the infinite
individual itself the whole of the purposes and interests of the finite
individuals must form a single harmonious system. This system
cannot itself be in the spatial and temporal form; space and time
must thus in some way cease to exist, as space and time, for the
absolute experience. They must, in that experience, be taken up,
rearranged, and transcended, so as to lose their character of an
endless chain of relations between other relations.
Precisely how this is effected, we, from our finite standpoint,
cannot presume to say. It is natural to draw illustrations from the
“specious present” of perception, in which we appear to have a
succession that is also simultaneous; or again, from the timeless and
purely logical character science seeks to ascribe to its “laws of
nature.” But in the “specious present” we seem obliged to attend to
one aspect, succession or simultaneity, to the exclusion of the other;
probably we never succeed in equally fixing both aspects at once. It
thus presents us rather with the problem than with its solution. And
again, after our discussion of the meaning of law, we cannot affirm
that Nature is, for the absolute experience, a system of general laws.
Hence it seems well not to take these illustrations for more than they
are actually worth as indications of the merely phenomenal character
of time. Metaphysics, like the old scholastic theology, needs
sometimes to be reminded that God’s thoughts are not as ours, and
His ways, in a very real sense when Philosophy has done its best,
still past finding out.[155]

Consult further:—F. H. Bradley, Appearance and Reality, chaps. 4

(Space and Time), 18 (Temporal and Spatial Appearance); L.
Couturat, L’Infini Mathématique, pt. 2, bk. iv. chap. 4 (against the
Kantian antinomies); H. Poincaré, La Science et L’Hypothèse, pp.
68-109; H. Lotze, Metaphysic, bk. ii. chaps. 1-3; W. Ostwald,
Vorlesungen über Naturphilosophie, lects. 5, 8; J. Royce, The World
and the Individual, Second Series, lect. 3; B. Russell, Foundations of
Geometry: Is Position in Space and Time Absolute or Relative (Mind,
July 1901), Principles of Mathematics, pt. 6, vol. i.; H. Spencer, First
Principles, pt. 2, chap. 3.
 141. The student who desires to think out the problems for himself
would probably do well to take the discussions of Locke (Essay, bk.
ii. chaps. 13-15) and Hume (Treatise of Human Nature, bk. i. pt. 2)
rather than that of Kant as his starting-point, as they are less vitiated
by psychological superstitions. In recent metaphysical work the
chapters on the subject in Mr. Bradley’s Appearance and Reality will
probably be found most useful. Much may be learned from Mr.
Russell’s work, Foundations of Geometry, with which should,
however, be compared the largely discrepant results of his later
article, “Is Position in Space and Time Relative or Absolute?” (Mind,
July 1901).
142. We are not called upon to enter into such specially
psychological questions as, e.g., whether both directions, past and
future, can be detected within the “specious present” of direct
perception, or whether the specious present only contains the
elements “now” and “no longer,” the “not yet” being a subsequent
intellectual construction, as is held, e.g., by Mr. Bradley and Mr.
Shadworth Hodgson.
143. We may indeed go still further, and say that every unique
moment or experience has its own unique spatial and temporal
system. The method by which I weave the perceived space-time
systems of different experiences within my own mental life into a
single conceptual system, is in principle the same by which the
spaces and times of myself and other men are made into one
system for the purpose of practical intercourse.
144. For an account of the psychological processes involved in all
this, see, e.g., Stout, Manual of Psychology,3 bk. iii. pt. 2, chaps. 3-5;
bk. iv. chap. 6.
145. Thus Dedekind (Was sind und was sollen die Zahlen? p. xii.)
maintains that none of the constructions of Euclid involve the
continuity of space.
146. Of course, a physical vacuum is not the same thing as empty
space. For the purposes of any special science a vacuum means a
space not occupied by contents of the special kind in which that
special science is interested. Thus, in the ordinary parlance of
Physics, a vacuum means simply a space in which there is no mass.
Whether it is desirable, for the purposes of physical science, to
assume the existence of vacuum, is altogether a question for
Physics itself, and to decide it in the affirmative is not to maintain the
existence of that unmeaning abstraction, absolutely empty space. In
any case, it may be observed that the widespread notion that motion
is only possible in a physical vacuum is a mistake, motion being
perfectly possible in a fluid plenum.
147. It must be carefully noted that distance as thus defined is not
properly a quantitative relation, and involves no notion of magnitude,
but only of relative place in a series. It should also be observed that
in assuming the existence of such a unique relation between every
pair of points, it is tacitly taken for granted that the number of
dimensions of the spatial order is finite. In a space of an infinite
number of dimensions, such unique relation would be impossible.
(See Russell, Foundations of Geometry, p. 161 ff.) Our justification
for making this assumption, as also for taking time to be of one
dimension only, seems to be that it is indispensable for all those
practical purposes which depend on our ability to create a science of
Geometry, and that we have no positive ground for assuming the
opposite. Thus ultimately the assumption appears to be of the nature
of a postulate.
148. The ablest detailed account of the relativity of spatial position
readily accessible to the English reader, will be found in Mr. Russell’s
Foundations of Geometry, chaps. iiiA, iv. Mr. Russell has since, in
Mind for July 1901, attempted to prove the opposite view, that
positions in space and time are inherently distinct, but without
discussing his own previous arguments for relativity. Into the purely
mathematical part of Mr. Russell’s later contentions I am not
competent to enter. I may, however, suggest that the question of
Metaphysics cannot be decided merely by urging, as Mr. Russell
does, that fewer assumptions are required to construct a geometry
on the hypothesis of absolute than on that of relative position. The
superior convenience of an assumption for certain special purposes
is no proof of its ultimate intelligibility. And when Mr. Russell goes on
to admit that points in space are indistinguishable for us, he seems
to me to give up his case. For is not this to admit that, after all, the
space with which we deal in our geometrical science is relative from
beginning to end? How differences of quality of which we, by
hypothesis, can know nothing, can help or hinder our scientific
constructions, it is indeed hard to see.
149. This may be brought home even to those who, like myself,
are not mathematicians, by the perusal of such a work as
Lobatchevsky’s Untersuchungen zur Theorie der Parallel-Linien,
where a consistent geometry of triangles is constructed in entire
independence of the postulate of parallelism. Of course, in the end it
must be a mere question of nomenclature whether a form of serial
order independent of these quasi-empirical restrictions is to be called
“space” or not.
150. It must be carefully remembered that the essential defect of
the indefinite regress is not its interminableness, but its monotony.
We ourselves held that Reality is an individual composed of lesser
individuals which repeat the structure of the whole, and that the
number of these individuals need not be finite. But, in our view, the
higher the order of individuality the more self-explanatory was its
structure, whereas in the indefinite regress an incomprehensible
construction is endlessly repeated in the same form.
151. Normally, that is; for brevity’s sake I omit to note the possible
case of a coherent dream-life continued from night to night. In
principle there would be a difference between the case of the space
and time of such a dream-life and those of our waking hours.
152. So the events of my dreams, though not occupying any place
in the temporal series of the events of waking life, are so far logically
connected with that series as both sets of events stand in relation to
certain identical elements of psychical temperament and disposition.
Another interesting case is that of so-called “dual personality.” The
experience of both the two alternating personalities can be arranged
in a single temporal series only because of the way in which both
sets are inwoven with the systematic interests of other men, whose
personality does not alternate, or alternates with a different rhythm. If
all mankind were subject to simultaneous alternations of personality,
the construction of a single time-series for all our experiences would
be impossible. In this discussion I have throughout followed the full
and thorough treatment of the problem by Mr. Bradley, Appearance
and Reality, chap. 18.
 153. Otherwise, conceptual space and time are, as we have seen,
derivatives of the number-series, and we have already learned that
the number-series leads to the problem of summing an endless
series, and is therefore not an adequate way of representing ultimate
Reality. (Bk. II. chap. 4, § 10). Another form of the same difficulty
would be that conceptual space and time are applications of the
numerical series,—but application to what? To a material which is
already spatial and temporal. All these puzzles are only different
ways of expressing the essential relativity of space and time. But see
the anti-Kantian view in, e.g., Couturat, L’Infini Mathématique, pt. 2.
154. Compare Prof. Royce’s remarks, The World and the
Individual, Second Series, lect. 3, “The Temporal and the Eternal,” p.
134. I should certainly have had to acknowledge considerable
obligation to Prof. Royce’s discussion had not the present chapter
been written before I had an opportunity of studying it.
155. Against the plausible attempt to solve the problem by simply
thinking of the whole physical order as forming a “specious present”
to the Absolute Experience, we may urge that the “specious present”
itself regularly consists for us of a multiplicity of detail, which we
apprehend as simultaneous without insight into its inner unity as the
embodiment of coherent system. Hence the direct insight of the
Absolute Experience into its own internal meaning or structure
cannot be adequately thought of as mere simultaneous awareness
of the detail of existence. So long as a succession is merely
apprehended as simultaneous, its meaning is not yet grasped.
 CHAPTER V

SOME CONDITIONS OF EVOLUTION

§ 1. The concept of evolution an attempt to interpret natural processes in terms of
individual growth. § 2. Evolution means change culminating in an end which is
the result of the process and is qualitatively new. The concept is thus
teleological. § 3. Evolution, being teleological, is essentially either progress or
degeneration. If it is more than illusion, there must be real ends in the physical
order. And ends can only be real as subjective interests of sentient beings
which are actualised by the process of change. § 4. Thus all evolution must
take place within an individual subject. § 5. Further, the subject of evolution
must be a finite individual. All attempts to make “evolution” a property of the
whole of Reality lead to the infinite regress. § 6. The distinction between
progressive evolution and degeneration has an “objective” basis in the
metaphysical distinction between higher and lower degrees of individuality. §
7. In the evolutionary process, old individuals disappear and fresh ones
originate. Hence evolution is incompatible with the view that Reality consists
of a plurality of ultimately independent finite individuals.

§ 1. We saw, in the first chapter of the present Book, that evolution

or orderly development is a fundamental characteristic of the
processes which compose the physical order as apprehended by the
various empirical sciences. For the purposes of Mechanics and
Mechanical Physics, indeed, we have no need to look upon Nature
as the scene of development; for these sciences it is enough to
conceive of it as a vast complex of changes of configuration and
transformations of energy, connected by regular uniformities of
sequence. As soon, however, as we come to regard Nature from the
standpoint of those sciences which explicitly recognise differences of
quality, as well as differences in position and quantity, among the
objects with which they deal, this narrowly mechanistic conception of
natural processes becomes inadequate. With the notion of physical
processes as productive of changes of quality we are inevitably led
to think of the physical order as a world in which the qualitatively new
is derived from, or developed out of, the previously familiar by fixed
lines of deviation and under determinate conditions.
 Naturally enough, it is from the biological sciences, in which the
study of organic growth plays so prominent a part, that the impulse
to conceive of physical change as development originally comes. As
long ago as the fourth century B.C., Aristotle had taken the concept of
growth or development as the foundation of the most influential
scheme of metaphysical construction yet produced in the whole
history of speculation. In Aristotle’s view, however, the process of
development was regarded as strictly confined within the limits of the
individual life. The individual organism, beginning its existence as an
undeveloped germ or potentiality, gradually unfolds itself in a series
of successive stages of growth, which culminates at the period of
complete maturity. But the individual germ itself is a product or
secretion derived from a pre-existing mature individual of the same
type as that into which this germ will ultimately grow. The number of
distinct typical processes of growth is thus strictly determined, and
each such process implies the previous existence of its completed
result. In other words, the boundaries between species are fixed and
ultimate; there can be no beginning in time of the existence of a new
species, and therefore no origination of new species by development
from other types. As Aristotle epigrammatically puts it, “It takes a
man to beget a man.”
A further point of weakness in the Aristotelian theory is the
absence of any definite account of the machinery by which the
process of growth is effected. We learn, indeed, that the latent
capacity of the organic germ to develop according to a certain
specific type is stimulated into activity by influences contained in the
environment, but the precise nature of this process of stimulation
was necessarily left in obscurity, in consequence of the imperfect
knowledge possessed by Aristotle of the minute character of natural
processes in general.
In the evolutionary theories of modern biology, it is precisely the
problems of the origination of new species, and of the special
character of the relations between the species and its environment
by which this process is conditioned, that have attracted almost
exclusive attention. And, with the steadily increasing success of
evolutionary hypotheses in dealing with biological problems, there
has naturally arisen a tendency to extend the application of the
general concept of evolution far beyond the sphere in which it first
originated. We have now not only more or less well-accredited
hypotheses of the production by evolution of our chemical elements,
but even ambitious philosophical constructions which treat the
concept of evolution as the one and only key to all the problems of
existence. In the presence of these far-reaching applications of
evolutionary ideas, it becomes all the more necessary to bear in
mind, in our estimate of the worth of the evolution concept, that its
logical character remains unaltered by the extension of its sphere of
applicability; it is still, in spite of all minor modifications, essentially
an attempt to interpret natural processes in general in terms of
individual growth.
We are not, of course, in the present chapter in any way
concerned with the details of any one particular theory as to the
special conditions which determine the course of organic or other
evolution. What those conditions in any special case are, is a
question, in the first instance, for that particular branch of empirical
science which deals with the description of the particular aspect of
the processes of the physical order under investigation. And though
it would be a proper question for a complete Philosophy of Nature
how the details of a well-established scientific theory must be
interpreted so as to harmonise with the general metaphysical
implications of the physical order, it is for many reasons premature to
raise such a question in the present state of our actual knowledge of
the details of evolutionary processes. All that can be done here is to
ask what in general are the logical implications involved in thinking of
a process as an evolution at all, and how those implications are
related to our general interpretation of the physical order.
§ 2. Evolution obviously involves the two concepts, already
criticised at length, of change and the dependence of the order and
direction of change upon determinate conditions. But an evolutionary
process is never a mere orderly sequence of changes. For instance,
the changes of configuration and exchanges of energy which take
place when work is done in a material system, conceived as
composed of moving masses without any element of secondary
quality, are not properly to be called a process of evolution. They are
not an evolution or development, because, so long as we keep to the
strictly kinetic view of natural processes as consisting solely in the
varying configuration of systems of mass-particles, the end of the
process is qualitatively undistinguishable from its beginning; nothing
qualitatively new has emerged as its result. Or rather, to speak with
more accuracy, the process has really no end and no unity of its
own. It is only by an entirely arbitrary limitation of view, due to purely
subjective interests of our own, that we isolate just this collection of
mass-particles from the larger aggregate of such particles which
form the physical order as regarded from the strictly kinetic
standpoint, and call it one system; and again, it is with equal
arbitrariness that we determine the point of time beyond which we
shall cease to follow the system’s changes of configuration. In the
indefinitely prolonged series of successive configurations there is no
stage which can properly be called final. Hence from the rigidly
mechanistic point of view of Kinetics and Kinematics there are no
evolutions or developments in the universe, there is only continuous
change.
Development or evolution, then, definitely implies the culmination
of a process of change in the establishment of a state of things
which is relatively new, and implies, further, that the relatively new
state of things may truly be regarded as the end or completion of this
special process of change. Thus the fundamental peculiarity of all
evolutionary ideas is that they are essentially teleological; the
changes which are evolutions are all changes thought of as
throughout relative to an end or result. Except in so far as a process
of change is thus essentially relative to the result in which it
culminates, there is no sense in calling it a development. We may
see this even by considering the way in which the concepts of
evolution and development are used in the various departments of
Physics. We sometimes speak of a chemical process as marked by
the “evolution” of heat, or again we say that, if the second law of
Thermo-dynamics is rigidly and universally true, the physical
universe must be in a process of evolution towards a stage in which
none of its energy will be available for work. But we can only attach a
meaning to such language so long as we allow ourselves to retain
the common-sense point of view according to which there are real
qualitative differences between what abstract Mechanics treats as
equivalent forms of “energy.”
We can speak of the evolution of heat, just because we,
consciously or unconsciously, think of heat as being really, what it is
for our senses, something qualitatively new and distinct from the
other kinds of energy which are converted into it by the chemical
process. So we can intelligibly talk of the gradual conversion of one
form of energy into another as an evolution only so long as we
regard the various forms of energy as qualitatively different, and are
therefore entitled to look upon the complete conversion of the one
into another as the qualitatively new result of a process which is
therefore terminated by its complete establishment. From the
standpoint of the physical theories which regard the distinction
between the forms of energy as only “subjective,” there would be no
sense in regarding that particular stage in the course of events at
which one form of energy disappeared as the end or result of a
process which terminates in it, and thus such terms as evolution and
development would lose their meaning. Only the establishment of
the qualitatively new can form a real end or result, and so afford a
logical basis for the recognition of the changes in the physical order
as distinct processes of development.
§ 3. This essentially teleological character of development is
emphasised in the language of the biological sciences by the
constant use of the concepts of progress and degeneration. For
biology an evolution is essentially a process either in the progressive
or in the regressive direction. Every evolution is an advance to a
“higher” or a decline to a “lower” state of development. Now progress
and regress are only possible where the process of change is
regarded as throughout relative to the end to be attained by the
process. Exactly how we conceive this end, which serves us as a
standard for distinguishing progress from degeneration, is a
secondary question; the point of fundamental importance is that,
except in reference to such an end, there can be no distinction at all
between progressive and retrogressive change. Thus, unless there
are really ends in the physical order which determine the processes
of change that culminate in their actual establishment, evolution
cannot be real. If the ends, by the establishment of which we
estimate progress in development, are merely arbitrary standards of
our own to which nothing in external reality corresponds, then the
physical order must really be a mere succession of changes which
are in no true sense developments, and the whole concept of nature
as marked by development will be a mere human delusion. And, on
the contrary, if there is any truth in the great scientific conceptions of
evolution, there must be real ends in the physical order.
Now, there is only one intelligible way in which we can think of a
process of change as really relative to an end. The resultant state
which we call the end of the process, as being the final stage which
completes this special process, and enables us to mark off all that
succeeds it as belonging to a fresh process of development, must
also be its end in the sense of being the conscious attainment of an
interest or purpose underlying the whole process. It is only in so far
as any state of things is, for some sentient being, the realisation of a
subjective interest previously manifested in an earlier stage of
experience, that that state of things forms the real culmination of a
process which is distinguished from all other processes, and
stamped with an individuality of its own, by the fact that it does
culminate in precisely this result. The conceptions of end or result
and of subjective interest are logically inseparable. Hence we seem
forced to infer that, since evolution is an unmeaning word, unless
there are genuine, and not merely arbitrarily assigned, ends
underlying the processes of physical nature, the concept of evolution
as characteristic of the physical order involves the metaphysical
interpretation of that order as consisting of the teleological acts of
sentient beings, which we had previously accepted on more general
grounds. It would be useless to attempt an escape from this
conclusion by drawing a distinction between two meanings of
“end”—“a last state” and “the achievement of a purpose.” For the
whole point of the preceding argument was that nothing can be an
“end” in the former sense without also being an end in the latter.
Unless processes have ends which are their subjective fulfilment, it
is only by an arbitrary convention of our own that we assign to them
ends which are their last states. And if it is only an arbitrary
convention that physical processes have ends in this sense,
evolution itself is just such a convention and nothing more.[156]
 § 4. What is in principle the same argument may be put in another
form, and the equivalence of the two forms is itself very suggestive
from the metaphysical point of view. Evolution or development, like
all change, implies the presence throughout successive stages in a
process of something which is permanent and unchanging. But it
implies something more definite still. Whatever develops must
therefore have a permanent individual character of its own of which
the successive stages in the development process are the gradual
unfolding. Unless the earlier and the later stages in a connected
series of changes belong alike to the gradual unfolding, under the
influence of surroundings, of a single individual nature, there is no
meaning in speaking of them as belonging to a process of
development. Only the individual can develop, if we are to attribute
precise meaning to our words. We speak of the evolution of a society
or a species, but if our words are not to be empty we must mean by
such phrases one of two things. Either we must mean that the
species and the society which develop are themselves individuals of
a higher order, no less real than the members which compose them,
or our language must be merely a way of saying that the life of each
member of the social or biological group exhibits development.
When we reflect on what is really involved in our ordinary loose
expressions about the “inheritance” of this or the other physical or
social trait, we shall see that the former alternative is far less
removed from ordinary ways of thought than might at first seem to be
the case. If any kind of reality corresponds to our current metaphor
of the “inheritance” of qualities, the groups within which such
“inheritance” takes place must be something much more than mere
aggregates of mutually exclusive individuals. A group within which
qualities can be thus inherited must, as a whole, possess a marked
individual nature of its own. Now we have already seen that all
individuality is in the end teleological. A group of processes forms an
individual life in the degree to which it is the expression of a unique
and coherent interest or aim, and no further. Hence, once more, only
what is truly individual can develop or evolve. And we readily see
that it is precisely in so far as a set of processes form the expression
of individual interest, that the demarcation of the group as a
connected whole from all previous and subsequent processes
possesses more than a conventional significance. Hence only
processes which are the expression of individual interest possess
“ends” or “last states,” and thus the two forms of our argument are in
principle identical. Once more, then, the significance of evolutionary
ideas, if they are to be more than a purely conventional scheme
devised for the furtherance of our own practical purposes, and as an
artificial aid to classification, is bound up with the doctrine that the
events of the physical order are really the expression of the
subjective interests of sentient subjects of experience.[157]
§ 5. To proceed to a further point of the utmost importance. Not
only does evolution imply the presence of individuality in the subject
of the evolutionary process; it implies its possession of finite
individuality. An infinite individual cannot have development or
evolution ascribed to it without contradiction. Hence the Absolute,
the Universe, or whatever other name we prefer to give to the infinite
individual whole of existence, cannot develop, cannot progress,
cannot degenerate. This conclusion might be derived at once from
reflecting upon the single consideration that temporal succession is
involved in all evolution, whether progressive or retrogressive. For
temporal succession is, as we have seen, an inseparable
consequence of finite individuality. But it will be as well to reach our
result in a different way, by considering certain further implications of
the concept of evolution which are manifestly only present in the
case of finite individuality.
In every process of development or evolution there are involved a
pair of interrelated factors, the individual nature which develops, and
the environment which contains the conditions under which and the
stimuli in response to which it develops. The undeveloped germ is as
yet a mere possibility, something which will yet exhibit qualities not
as yet possessed by it. In its undeveloped state, what it possesses is
not the qualities characteristic of its later stages, but only
“tendencies” or “dispositions” to manifest those qualities, provided
that the environment provides the suitable stimulus. Hence, if either
of the two interrelated factors of development, the individual or the
environment, is missing, there can be no evolution. Now, the infinite
individual whole of existence has no environment outside itself to
supply conditions of development and incentives to change. Or, what
is the same thing, since the “possible” means simply that which will
follow if certain conditions are realised, there is no region of
unrealised possibility outside the realised existence of the infinite
whole. Hence in the infinite whole there can be no development: it
cannot progressively adapt itself to new conditions of existence; it
must once and for all be in its reality all that it is in “idea.” The infinite
whole therefore evolves neither forward nor backward.
This impossibility of ascribing development to the whole of Reality
is strikingly illustrated by a consideration of the impasse into which
we are led when we try in practice to think of the whole universe as
in process of evolution. So long as you are still in the presence of the
fundamental distinction between the developing subject and its
environment, you are logically driven, if everything is to be taken as
a product of evolution, to supplement every evolutionary theory by a
fresh evolutionary problem. To account for this special evolution
(e.g., the evolution of the vertebrata) you have to assume an
environment with determinate qualities of its own, influencing the
evolution in question in a determinate way in consequence of these
qualities. But if everything has been evolved, you have again to ask
by what process of evolution this special environment came to be
what it is. To solve this problem you have once more to postulate a
second “environment” determining, by interaction, the course of the
evolution of the former. And thus you are thrown back upon the
indefinite regress.
Unless, indeed, you are prepared boldly to assert that, as all
determinate character is the product of evolution, the universe as a
whole must have evolved out of nothing. (You would not escape this
dilemma by an appeal to the very ancient notion of a “cycle” or
“periodic rhythm” of evolution, in virtue of which the product of a
process of evolution serves in its turn as the environment for the
reiterated evolution of its own antecedent conditions, A thus passing
by evolution into B and B back again into A. For you would at least
have to accept this tendency to periodic rhythm itself as an ultimate
property of all existence, not itself resulting by evolution from
something else.) The dilemma thus created by the attempt to apply
the concept of evolution to the whole of Reality, is sufficient to show
that evolution itself is only thinkable as a characteristic of processes
which fall within the nature of a system which, as a whole, does not
evolve.
We may restate the same contention in the following form:—All
development means advance towards an end. But only that which is
as yet in imperfect possession of its end can advance towards it. For
that which already is all that it has it in its nature to be there can be
no advance, and hence no progressive development. Neither can
such a complete individual degenerate. For even in degenerating,
that which degenerates is gradually realising some feature of its own
nature which was previously only an unrealised potentiality. Thus
even degeneration implies the realisation of an end or interest, and
is itself a kind of advance[.] As the biologists tell us, the atrophy of an
organ, which we call degeneration, is itself a step in the progressive
adaptation of the organisation to new conditions of life, and, as the
moralists remind us, in the ethical sphere a “fall” is, in its way, an
upward step. Hence what cannot rise higher in the scale of existence
also cannot sink lower.
§ 6. Evolution is thus an inseparable characteristic of the life of
finite individuals, and of finite individuals only. And this consideration
gives us the clue to the metaphysical interpretation of the distinction,
so significant for all evolutionary theory, between the progressive
and retrogressive directions of the evolution process. To a large
extent it is, of course, a matter of convention what we shall regard as
progress and what as degeneration. So long as we are specially
interested in the attainment of any end or culminating result, we call
the line of development which leads up to that result progressive,
and the line which leads to its subsequent destruction degeneration.
And thus the same development may be viewed as progress or as
degeneration, according to the special character of the interests with
which we study it. Thus, for instance, the successive modifications of
the vertebrate structure which have resulted in the production of the
human skeleton are naturally thought of as progressive, because our
special interest in human intelligent life and character leads us to
regard the human type as superior to its predecessors in the line of
development. At the same time, many of these modifications consist
in the gradual loss of characteristics previously evolved, and are
therefore degenerative from the point of view of the anatomical
student, who is specially interested in the production of organs of
increasing complexity of structure, and therefore takes the
complexity of those structures as his standard in distinguishing
progress from retrogression.
But the distinction is not a purely conventional one. As we have
seen, degrees of individuality are also degrees of reality; what is
more completely individual is also a completer representative of the
ultimate structure of the infinite individual whole, and therefore more
completely real. Hence we may say that advance in individuality is
really, and not in a merely conventional sense, progress in
development; loss of individuality is real degeneration. Thus we get
at least the possibility of a true “objective” basis for distinction
between the directions of evolutionary progress. But we must
remember that it is only where we are able to know something of the
actual interests of finite experiencing beings that we have safe
grounds for judging whether those interests receive more adequate
embodiment in consequence of the changes of structure and habit
produced by evolution or not. Hence, while our insight into the inner
lives of ourselves and our animal congeners theoretically warrants
us in pronouncing the various developments in human social life to
be genuinely progressive or retrogressive, and again in regarding the
series of organic types which leads directly up to man as a true
“ascent,” our ignorance of the special character of the individual
experiences of which the inorganic physical order at large is the
phenomenal manifestation, makes it impossible for us to determine
whether an “evolution” outside these limits is really progressive or
not. We have to treat “cosmic evolution” in general, outside the
special line of animal development which leads up to man, as
indifferently a “progress” or a “degeneration” according to our own
arbitrary point of view, not because it is not “objectively” definitely the
one or the other, but because our insight is not sufficient to discern
which it is.
§ 7. One more point may be noted, which is of some importance in
view of certain metaphysical problems connected with the nature of
finite individuality. If evolution is more than an illusion, it seems
necessary to hold that it is a process in the course of which finite
individuals may disappear and new finite individuals originate. This
point is metaphysically significant, because it means that the fact of
evolution is irreconcilable with any of the philosophical theories of
ancient and modern times, which regard Reality as composed of a
plurality of ultimately independent finite individuals or
“personalities.”[158] If these philosophical theories are sound, the
course of the world’s history must be made up of the successive
transformations of finite individuals, who somehow remain
unaffected and unaltered in their character by the various external
disguises they assume. The individuals of such a philosophy would,
in fact, be as little modified by these changes as the actors on a
stage by their changes of costume, or the souls of the
“transmigration” hypothesis by the bodies into which they
successively enter. And thus development would not be even a
relatively genuine feature of the life of finite individuals; it would be a
mere illusion, inevitable indeed in the present condition of our
acquaintance with the detailed contents of existence, but
corresponding to no actual fact of inner experience.
On the other hand, if evolution is not a pure illusion, these
metaphysical constructions cannot be valid. For the whole essence
of the modern doctrine of evolution is contained in the principle that
radical differences in kind result from the accumulation of successive
modifications of individual structure, and once established continue
to be perpetuated as differences in kind. Now, such differences in
kind can only be interpreted metaphysically as radical differences in
the determining aims and interests of the experiencing subjects
constituting the physical order, and we have already seen that it is
precisely the character of these dominant unique interests which
forms the individuality of the individual. Thus the metaphysical
interpretation of the evolution process seems inevitably to resolve it
into a process of the development of fresh and disappearance of old
individual interests, and thus into a process of the origination and
disappearance of finite individuals within the one infinite individual
whole.
A conclusion of the same sort would be suggested by
consideration of those facts of our own individual development from
which the wider evolutionary theories have, in the last resort,
borrowed their ideas and their terminology. The mental growth of the