Brealey, Myers. Principles of Corporate Finance. 7th edition
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Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Appendix B Answers to
Quizzes
© The McGraw−Hill
Companies, 2003
9.
•
Negative pledge clause—if secured debt is is-
sued, existing debt will also become secured.
3. (a) Decreases; (b) impossible to say; (c) impossible to
say. For example, if the bond has a high coupon and
is sold at a premium at issue, the prospect of draw-
ings at par could decrease value. For an original-
issue discount bond, the effect could be reversed.
4. a. You would like an issue of junior debt.
b. You prefer it not to do so (unless it is also junior
debt). The existing property may not be suffi-
cient to pay off your debt.
5. (a) First Boston, Goldman Sachs, Shearson Lehman,
Stifel Nicholaus; (b) Continental Bank; (c) $967.25;
(d) registered; (e) 104.26 (percent of par); (f) no.
6. a. Issue price approximately 1 month’s interest
976.00 95/12 $983.92.
b. December 1, 1986; $47.50.
c. 2016. The sinking fund was designed to pay off all
but $8.64 million of principal by that date. The com-
pany must pay off the remaining $8.64 million.
d. 2002.
7. The 7.8 percent rate is actually 3.9 percent semian-
nually. The effective annual rate is 1.039
2
1
.0795, slightly higher than the London quote. In-
ternational bonds pay interest annually.
8. Private placements: typically have simpler loan
agreements—which may nevertheless contain
“custom” features; have more stringent covenants;
are more easily renegotiated.
9. a. False. Lenders usually retain some recourse;
e.g., they may demand a completion guarantee.
b. True, but some new securities (e.g., zero-coupon
bonds) survive even when the original motive
for issuing them disappears.
APPENDIX B Answers to Quizzes 1033
Proportion
of Total Proportion
Year C
t
PV(C
t
) Value Time
Security A 1 40 37.04 .359 .359
2 40 34.29 .333 .666
3 40 31.75 .308 .924
V 103.08 1.0 Duration 1.949 years
Security B 1 20 18.52 .141 .141
2 20 17.15 .131 .262
3 120 95.26 .728 2.184
V 130.93 1.0 Duration 2.587 years
Security C 1 10 9.26 .088 .088
2 10 8.57 .082 .164
3 110 87.32 .830 2.490
V 105.15 1.0 Duration 2.742 years
Volatilities: A, 1.80; B, 2.40; C, 2.49.
10. a.
b. The expected 1-year spot rate at time 1 equals
the forward rate f
2
.
c. Against (unless one believes that investors have
generally expected interest rates to rise).
d. The forward rate equals the expected spot rate
plus a liquidity premium.
e. Long-term bonds.
f. Short-term bonds.
11. a. Aaa, Aa, A, and Baa
b. (i) Increase; (ii) increase; (iii) increase; (iv) increase.
12. Option to put (i.e., sell) company assets to the
bondholders for the face value of the debt.
13. Value an option to put (i.e., sell) the company’s as-
sets to the government for the amount of the loan.
Chapter 25
1. (a) High-grade utility bonds; (b) industrial holding
companies; (c) industrial bonds; (d) railroads;
(e) asset-backed security.
2.
• Indenture or trust deeds—agreement between
the borrower and a trust company representing
bondholders.
• Debentures—long-term unsecured bonds.
• Mortgage bonds—debt secured by property.
• Call provision—company has right to call and
pay off debt.
• Sinking fund—provision for repayment of part
or most of principal prior to maturity.
• Foreign bond—bond sold in another country’s
market.
f
2
.05, or 5%.
1.03
2
1.01 11 f
2
2
11 r
2
2
2
11 r
1
211 f
2
2
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Appendix B Answers to
Quizzes
© The McGraw−Hill
Companies, 2003
c. False. The borrower has the option.
d. True. But debt issues with weak covenants suf-
fered in such takeovers.
e. True. The costs of renegotiation are less for pri-
vate placements.
10. Chapter 7 usually leads to liquidation. Chapter 11
“protects” the firm from its creditors while a reor-
ganization plan is developed.
11. (a) False; (b) true; (c) true, except for costs incurred by
the bankruptcy court or trustee; (d) true; (e) false.
Tax-loss carry-forwards do not survive liquidation.
12. There is always a chance that the company can re-
cover, allowing creditors to be paid off and leaving
something for shareholders. Also, shareholders
may retain some claims on the firm after reorgani-
zation in Chapter 11.
Chapter 26
1. A, c; B, d or i; C, b or e; D, f; E, a; F, h; G, g.
2. a, b, d, f, and h (though there may be other ways to
reduce AMT).
3. a. The lessor must charge enough to cover the
present value of the costs of owning and operat-
ing the asset over its expected economic life. In a
competitive leasing market the present value of
rentals cannot exceed the present value of costs.
The competitive rental payment ends up equal
to the lessor’s equivalent annual cost.
b. The user’s equivalent annual cost is the annual
cost to the user of owning and operating the as-
set. If the operating lease rate is less than this
cost, it pays to lease.
4. (a) True; (b) true; (c) true, but compare after-
tax rates; (d) true; (e) true; (f) true; (g) true.
5. The present value of depreciation tax shields on the
$3,000 desk, using the 5-year schedule from Table
6.4, is
3,000
After-tax administrative costs are 400(1 .35) $260
per year for 6 years. If the first costs are incurred im-
mediately, their present value is $1,271. Thus the pres-
ent value of all costs is $3,000 832 1,271 $3,439.
The break-even lease rate is about $703 after tax. In
other words, the present value of six payments of
$703, with the first payment due immediately, is about
$3,439. The breakeven rate pretax is $703/.65 $1,082.
6. Administrative costs drop to $200 per year. More-
over, the lease payments are a fixed commitment of
$
ˇ 832.
PV 1at 9 percent2 .35 PV 15-year schedule2
the blue-chip company. The six lease payments are
discounted at the after-tax rate at which Acme
would lend money; that is, 6(1 .35) 3.9%. The
break-even lease rate falls to about $514 after tax.
The pretax break-even rate is $791.
7. a. $59,307; the present value of the lease cash flows
from t 1 to t 3, discounted at r(1 T
c
)
.10(1 .35) .065.
b. $62,000 59,307 2,693.
c. It should not invest. The lease’s value of 2,693
does not offset the machine’s negative NPV. It
would be happy to sign the same lease on a more
attractive asset.
Chapter 27
1. (a) True; (b) true; (c) false (depends on coupon);
(d) false; (e) false; (f) false; (g) true.
2. Since the futures price has risen, your sale is now
showing a loss. Your broker will ask you for money.
3. .
.
4. (convenience yield).
.
5. a. A shortage of heating oil increases net conven-
ience yield and reduces the futures price relative
to spot price.
b. Spot and futures prices decrease. The futures
price rises relative to spot because convenience
yield falls and storage costs rise.
6. Storage costs are likely to be high. Other things
equal, firms will prefer to hold the future rather
than the spot commodity, and net convenience
yield will be low.
7. (a) Profit; (b) If the bank took out a new 4-year
swap, it would need to pay an extra $.25 million a
year. At the new interest rate of 6.5%, the extra pay-
ment has a present value of $856,000. This is the
amount that the bank should charge to terminate.
8. Basis risk means that the hedging instrument is im-
perfectly correlated with the risk to be hedged. It is
highest in a, because Disney stock has considerable
nonmarket risk. In b basis risk is likely to be small,
and in c it should disappear.
9. Sell short $1.2 million of the market portfolio. In
practice rather than “sell the market” you would
sell futures on $1.2 million of the market index.
10. (a) Sell; (b) sell 3-month futures on Italian govern-
ment bonds.
PV 1convenience yield2 $
ˇ 500
2,408
1.12
2,550 100 PV
Value of future 95.46
Value of future
1.049
95 4
1034 APPENDIX B Answers to Quizzes
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Appendix B Answers to
Quizzes
© The McGraw−Hill
Companies, 2003
b. A has a duration of 1.949 years. So does a port-
folio with 45.5% invested in B and 54.5% in-
vested in C. To hedge A sell $4.55 million of B
and $5.45 million of C.
c. Sell $5.13 million of A, borrow 10 5.13 $4.87
million short-term. Alternatively, sell $3.65 mil-
lion of C and borrow $6.35 million.
APPENDIX B Answers to Quizzes 1035
Proportion
Year C
T
PV(C
T
) Proportion Time
1 120 111.11 1.0 1.0
20 0 0 0
30 0 0 0
V 111.11 1.0 Duration
1.0 years
Chapter 28
1. a. 9.139.
b. 9.1865 pesos $1.
c. premium.
d. Using the 1-year forward rate, (9.924
9.139)/9.924 .0791, or 7.91%.
e. By interest rate parity 1 r
peso
1.05
12.36/9.84; r
peso
.126, or 12.6%.
f. 9.307 pesos $1.
g. If real exchange rate is constant, expected infla-
tion in Mexico over 3 months must be
9.307/9.139 1 .018, or 1.8%, greater in Mex-
ico than in the USA (equivalent to 1.018
4
1
.076, or 7.6%, a year).
2. a. The interest rate differential equals the forward
premium or discount, i.e.,
b. The expected change in the spot rate equals the
forward premium or discount, i.e.,
1 r
x
1 r
$ˇ
f
x/$ˇ
s
x/$ˇ
.
c. Prices of goods in different countries are
equal when measured in terms of the same
currency. It follows that the expected change
in the spot rate equals the expected inflation
differential; i.e.,
d. Expected real interest rates in different countries
are equal; i.e.,
3. a. .
b. Real value of rupiah fell by 3,083/8,325 1
.63, or 63%.
2,419 1.3/1.02 R3,083 $
ˇ 1
1 r
x
1 r
$ˇ
E11 i
x
2
E11 i
$ˇ
2
E11 i
x
2
E11 i
$ˇ
2
E1s
x/$ˇ
2
s
x/$ˇ
.
f
x/$ˇ
s
x/$ˇ
E1s
x/$ˇ
2
s
x/$ˇ
4.
1 Month 3 Months 1 Year
Dollar interest rate, % 3.60 3.70 3.70
Peso interest rate, % 9.55 9.99 11.90
Forward pesos per dollar 53.85 54.40 57.844
Forward premium on
peso (% per year) 5.6 5.7 6.0
5. b.
6. Zero, of course. You don’t need to do any calculations.
7. It can borrow the present value of a1 million, sell
the euros in the spot market, and invest the pro-
ceeds in an 8-year dollar loan.
8. (a) (100/1.03)/(100/1.0365
2
) 1 .043, or 4.3%;
(b) 1.043
115/120.7 1 .006, or .6%;
(c) 1.043
116.52/120.7 1 .007 or .7%.
9. a. NPV
6.61 1.2 $7.94 million.
11. a. The calculations for A and C are given for Quiz
question 9, Chapter 24. For B, the calculations
change to
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Appendix B Answers to
Quizzes
© The McGraw−Hill
Companies, 2003
b.
c. True (financial planning considers both the in-
vestment and financing decisions).
d. False (a typical horizon for long-term planning
is 5 years).
e. True (perfect accuracy is unlikely to be obtain-
able, but the firm needs to produce the best pos-
sible consistent forecasts).
f. False (excessive detail distracts attention from
the crucial decisions).
14. (a) $2,900,000; (b) $225,000; (c) .25.
15. Archimedes will earn $550 and invest $320 to ex-
pand assets. Additional borrowing is $120, so re-
tained earnings is $320
120 $200. The residual
dividend is $550
200 $350.
16. (a) 8.6%; (b) 13.75%.
Chapter 30
1. a. Long-term financing, cumulative capital re-
quirements, marketable securities
b. Cash, cash, cash balance, marketable securities
c. Trial, error, financial models
2.
1036 APPENDIX B Answers to Quizzes
Year 0 1 2 3 4 5
Forward rate 1.2 1.223 1.246 1.269 1.293 1.318
$ million 96 12.23 24.91 29.19 34.92 32.94
c. It doesn’t. The company can always hedge
against a fall in the euro.
Chapter 29
1. (a) 5,114/(5114
6,832) .43; (b) (1,674 859)/351
7.2; (c) 3,288/2,704 1.2; (d) (115 1,247)/2,704
.5; (e) (1,674 483)/15,980 .07; (f) ((1,499 1,329)
2)/(12,035 365) 42.9; (g) 840/((6,832 7,173)
2) .120; (h) 263/840 .31.
2. The illogical ratios are a, b, c, f, and i. The correct
definitions are
3. (a) False; (b) true; (c) false; (d) false; (e) false—it will
tend to increase the price–earnings multiple.
4. (a) Shipping company; (b) United Foods; (c) pa-
per mill; (d) mail order company; (e) Fledgling
Electronics.
5. $365,000; 12.2.
6. (a) 12%; (b) 16%.
7. .25.
8. 3.65%; .73.
9. (a) 1.47; (b) Net working capital
40. Total capital-
ization
540. Debt to total capitalization .52.
10. $10 million.
11. $82 million.
12. The return on equity is higher when the return on
assets exceeds the debt interest rate.
13. a. False (it is a process of deciding which risks to
take).
b. False (financial planning is concerned with pos-
sible surprises as well as expected outcomes).
Average collection period
average receivables
sales 365
Current ratio
current assets
current liabilities
Payout ratio
dividend
earnings per share
Return on equity
earnings available for common
average equity
Debt–equity ratio
long-term debt value of leases
equity
Cash Working Capital
1. $2 million decline $2 million decline
2. $2,500 increase Unchanged
3. $5,000 decline Unchanged
4. Unchanged $1 million increase
5. Unchanged Unchanged
6. $5 million increase Unchanged
3. (a) Inventories go up (use). (b) Accounts receivable
go up (use). (c) No change shown on the firm’s
books. (d) Increase in cash (source) and reduction in
assets. A loss of $100,000 is deducted from retained
earnings. (e) Cash declines (use) and equity declines.
(f) Cash unchanged, although net working capital
increases (the debt issue is a source of funds).
4. Month 3: 18
(.5 90) (.3 120) (.2 100)
$119,000.
Month 4: 14
(.5 70) (.3 90) (.2 120)
$100,000.
5. (a) 19.2, 16.8, 15, 13.2, 12, 12; (b) 19.2, 23.2, 20.6, 18.2,
16.4, 16.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Appendix B Answers to
Quizzes
© The McGraw−Hill
Companies, 2003
6. a. Table 30.2: Bank loans 3, Cash 8, Current as-
sets
68, Current liabilities 30, Total assets
Total liabilities and net worth 118. Table 30.4:
Repaid short-term bank loan
2, Increase in cash
balance
4. Tables 30.5 and 30.6 unchanged.
b. Table 30.2: Long-term debt
22, Gross investment
82, Net fixed assets 62, Cash 3, Total assets
Total liabilities and net worth 125. Table 30.4:
Issued long-term debt
17, Total sources 41, In-
vested in fixed assets
26, Total uses 42, In-
creases in cash balance
1. Table 30.5: Fixed and
Total assets change as in Table 30.2, as do Long
term debt and Total liabilities and net worth. Table
30.6: same changes as in Table 30.4, except In-
crease in net working capital
6.
c. Table 30.3: Operating costs
289, Pretax income
56, Net income 28, Retained earnings 27.
Table 30.2: Net worth
92, Total liabilities and net
worth
Total assets 131; Inventory 22.5,
Cash
23.5. Table 30.5: Net worth 92, Long-
term liabilities and net worth
Total assets 104,
Net working capital
54. Table 30.6: Net income
28, increase in Net working capital 24.
d. Table 30.7: Third quarter, Total collections
120.1, Ending receivables 26.6. Fourth quarter,
Total collections
129.5, Ending receivables
28.1. Table 30.8, Third quarter: Sources minus
uses and Cash at end of period increase by 11.6,
Cumulative financing required decreases by
11.6. Fourth quarter: Sources minus uses in-
crease by 1.5, Cumulative financing required de-
creases by 13.1 to
12.6.
e. Table 30.8: Labor, etc.
26, Sources minus uses
decrease by 4 in each quarter. Cumulative fi-
nancing required decreases by 4 in first quarter,
8 in second, etc.
f. Table 30.8: Other sources of cash increase by 10
in the second quarter, increasing Sources mi-
nus uses and decreasing Cumulative financing
required.
g. Table 30.8: Minimum operating cash balance
2,
Cumulative financing required decreases by 2 in
all quarters.
7. (a) True; (b) false (borrower has a call); (c) true; (d)
false (100/90
1 .111, or 11.1%); (e) true.
8. (a) Line of credit; (b) commitment fee; (c) floating
charge; (d) collateral; (e) warehouse receipt; (f)
commercial paper; (g) medium-term notes.
Chapter 31
1. a. Payment float
$25,000. Availability float
$75,000.
b. It can earn interest on these funds.
c. Payment float increases. The bank’s gross ledger
balance and available balance increase by the
same amount.
2. a. The $.40 per check fee is cheaper at 300
.40
$120 per day. The cost of putting up $800,000 of
compensating balances is .09
800,000
$72,000 per year, or 72,000/365 $197 per day.
b. The lock-box system costs $120 per day, or $43,800
per year. You would need $486,700 additional
cash to generate this much interest. Thus, the lock-
box system must generate at least this much cash.
The cash flow is 300
1,500 $450,000 per day.
Thus the lock box must speed up average collec-
tion time by 486,700/450,000
1.08 days.
3. Payment float; availability float; net float; concentra-
tion banking; FEDWIRE; CHIPS; lock-box banking.
4. The formula for optimal order size is
Everyman should place 216/12 18 orders a year
and its average inventory should be 12/2 6 books.
5. The formula gives
$2,000.
Everyman should sell securities 20,000/2,000 10
times a year and its average cash balance should be
2,000/2 $1,000.
6. (a) Less; (b) less; (c) invest the same amount; (d) more.
7. Price 100 (182/360)1.75 99.115. Compound
annual return (100/99.115)
2
1 .0179, or 1.79%.
8. (a) Repurchase agreements; (b) commercial paper; (c)
finance company commercial paper; (d) medium-
term notes; (e) 3-month bills; (f) Treasury bills; (g)
Treasury bills.
9. Only 30% of the floating-rate preferred dividend is
taxed versus 100% of bond interest. The fixed-
dividend preferred also has this advantage but its price
fluctuates more than the floating-rate preferred’s.
Chapter 32
1. a. 1% of $1,000 $10.
b. 1% for 30 days 12.2% per annum simple inter-
est or 12.9% compound interest.
c. (i) Shorter; (ii) longer; (iii) shorter.
2. a. Due lag decreases, therefore pay lag decreases;
b. Due lag increases, therefore pay lag increases;
c. Terms lag increases, therefore pay lag increases.
212 20,000 22/.02
24,000,000
Q
B
12 annual cash disbursements2
1cost per sale of securities2/interest rate
212 216 22/6 2144 12 books.
Q 21 2 sales cost per order2/carrying cost
APPENDIX B Answers to Quizzes 1037
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Appendix B Answers to
Quizzes
© The McGraw−Hill
Companies, 2003
3. Open account, commercial draft, shipping docu-
ments, trade acceptance, the customer’s, banker’s
acceptance, letter of credit, the customer’s, his or
her own, letter of credit, shipping documents, ship-
ping documents.
4. Reject because PV of Q’s order (.75 50)/1.10
1/2
40 $4.25 per iron, or $4,250 in total.
5. a. Expected profit p(1,200 1,050) 1,050
(1 p) 0
Therefore, grant credit if probability of payment
exceeds 87.5%.
b. Expected profit from selling to slow payer:
.8(150) .2(1050) 90. Break-even point for
credit check: (.05 90 units) 12 0. Units
2.67.
6. Total expected profit on initial order 40 .8[(p
2
200) 1,000(1 p
2
)]/1.2 0
p
2
.88, or 88%.
7. (a) False; (b) true; (c) false; (d) false—should be col-
lection agency or attorney; (e) true.
Chapter 33
1. (a) Horizontal; (b) conglomerate; (c) vertical;
(d) conglomerate.
2. a and d; c can also make sense, although merging is
not the only way to redeploy excess cash.
3. (a) $5 million (We assume that the $500,000 saving
is an after-tax figure.); (b) $4 million; (c) $7.5 mil-
lion; (d) $1 million; (e) $2.5 million.
4. a, b.
5. (a) True; (b) false; (c) false; (d) true; (e) false (They
may produce gains, but “large” is stretching it.);
(f) false; (g) true.
6. Such companies are tempted to undertake nega-
tive-NPV investments. If they do, a bidder may try
to take over and force a cutback of investment.
7. a. Any premium paid by the bidder over the book
value of the target’s equity is reflected in the bid-
der’s balance sheet, e.g., it is shown as “goodwill.”
b. The bidder offers to buy the target’s stock di-
rectly from its shareholders.
c. The target’s stockholders can purchase addi-
tional shares at a bargain price.
d. The target purchases shares held by the bidder;
the bidder agrees to go away.
p .875
e. The target frustrates a hostile bidder by agreeing
to merge with a friendlier and more compatible
suitor.
Chapter 34
1. a. Purchase of a business using mostly debt fi-
nancing. The company goes private. Manage-
ment is given a substantial equity stake.
b. An LBO undertaken by management.
c. A parent company creates a new company with
part of its assets and operations. Shares in the
new business are distributed to the parent’s
stockholders.
d. Like a spin-off, but shares in the new business
are sold to investors.
e. Sale of specific assets rather than entire firm. A
company borrows to repurchase a large fraction
of its shares. Like an LBO, except that the com-
pany remains public.
f. A government-owned business is sold to private
investors.
g. A company moves to a much higher debt ratio.
Proceeds of additional borrowing are paid out to
stockholders.
2. (a) True; (b) false; (c) false; (d) true; (e) true; (f) false;
(g) false.
3. Increased efficiency, broader share ownership, and
revenue for the government.
4. a. Internal capital markets often misallocate capi-
tal. The market values of the conglomerate’s di-
visions can’t be observed separately, so it’s hard
to set incentives and to reward risk-taking.
b. In a smaller, developing economy, size may give
easier access to capital markets and make it eas-
ier to attract professional management. It may
also give political power. An internal capital
market may be helpful when external markets
are undeveloped or inefficient.
5. In Germany, banks own large, often controlling
stakes in nonfinancial corporations. In the U.S. this
is not allowed. In Japan, banks play central roles in
keiretsus, groups of companies linked by cross-
ownership.
6. Temporary conglomerates, such as LBO funds,
purchase businesses in different industries but not
to invest and manage for the long run. The objec-
tive is to buy, fix, and sell.
1038 APPENDIX B Answers to Quizzes
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Glossary
© The McGraw−Hill
Companies, 2003
A
Abnormal return Part of return that is not due to system-
atic influences, e.g., marketwide price movements.
Absolute priority Rule in bankruptcy proceedings
whereby senior creditors are required to be paid in full
before junior creditors receive any payment.
Accelerated depreciation Any depreciation method that
produces larger deductions for depreciation in the early
years of a project’s life.
Accounts payable (payables, trade debt) Money owed to
suppliers.
Accounts receivable (receivables, trade credit) Money
owed by customers.
Accrued interest Interest that has been earned but not
yet paid.
ACH Automated Clearing House.
Acid-test ratio Quick ratio.
Adjusted present value (APV) Net present value of an asset
if financed solely by equity plus the present value of any
financing side effects.
ADR American depository receipt.
Adverse selection A situation in which a pricing policy
causes only the less desirable customers to do business,
e.g., a rise in insurance prices that leads only the worst
risks to buy insurance.
Agency theory Theory of the relationship between a
principal, e.g., a shareholder, and an agent of the
principal, e.g., the company’s manager.
Aging schedule Record of the length of time that accounts
receivable have been outstanding.
All-or-none underwriting An arrangement whereby a
security issue is canceled if the underwriter is unable to
resell the entire issue.
American depository receipt (ADR) A security issued in
the United States to represent shares of a foreign
company.
American option Option that can be exercised any time
before the final exercise date (cf. European option).
Amex American Stock Exchange.
Amortization (1) Repayment of a loan by installments;
(2) allowance for depreciation.
Annual percentage rate (APR) Annual interest rate calcu-
lated using simple interest.
Annuity Investment that produces a level stream of cash
flows for a limited number of periods.
Annuity due Annuity whose payments occur at the start
of each period.
Annuity factor Present value of $1 paid for each of t
periods.
Anticipation Arrangements whereby customers who pay
before the final date may be entitled to deduct a normal
rate of interest.
Appraisal rights A right of shareholders in a merger to
demand the payment of a fair price for their shares, as
determined independently.
Appropriation request Formal request for funds for a
capital investment project.
APR Annual percentage rate.
APT Arbitrage pricing theory.
APV Adjusted present value.
Arbitrage Purchase of one security and simultaneous
sale of another to give a risk-free profit.
“Arbitrage” or “risk arbitrage” Often used loosely to
describe the taking of offsetting positions in related secu-
rities, e.g., at the time of a takeover bid.
Articles of incorporation Legal document establishing a
corporation and its structure and purpose.
Asian currency units Dollar deposits held in Singapore or
other Asian centers.
Asian option Option based on the average price of the
asset during the life of the option.
Ask price (offer price) Price at which a dealer is willing
to sell (cf. bid price).
Asset-backed securities Securities issued by a special
purpose company that holds a package of low-risk assets
whose cash flows are sufficient to service the bonds.
Auction-rate preferred A variant of floating-rate preferred
stock where the dividend is reset every 49 days by auction.
Authorized share capital Maximum number of shares
that a company can issue, as specified in the firm’s articles
of incorporation.
Automated Clearing House (ACH) Private electronic
system run by banks for high-volume, low-value
payments.
Availability float Checks deposited by a company that
have not yet been cleared.
Aval Bank guarantee for debt purchased by forfaiter.
B
BA Banker’s acceptance.
Backwardation Condition in which spot price of
commodity exceeds price of future (cf. contango).
Balloon payment Large final payment (e.g., when a loan
is repaid in installments).
Banker’s acceptance (BA) Written demand that has been
accepted by a bank to pay a given sum at a future date (cf.
trade acceptance).
Barrier option Option whose existence depends on asset
price hitting some specified barrier (cf. down-and-out
option, down-and-in option).
1039
GLOSSARY*
*Italicized words are listed elsewhere in the glossary.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Glossary
© The McGraw−Hill
Companies, 2003
Basis point (bp) 0.01 percent.
Basis risk Residual risk that results when the two sides of
a hedge do not move exactly together.
Bearer security Security for which primary evidence of
ownership is possession of the certificate (cf. registered
security).
Bear market Widespread decline in security prices (cf.
bull market).
Benchmark maturity Maturity of a newly issued
Treasury bond.
Benefit–cost ratio One plus profitability index.
Best-efforts underwriting An arrangement whereby
underwriters do not commit themselves to selling a
security issue but promise only to use best efforts.
Beta Measure of market risk.
Bid price Price at which a dealer is willing to buy (cf.
ask price).
Bill of exchange General term for a document
demanding payment.
Bill of lading Document establishing ownership of goods
in transit.
Blue-chip company Large and creditworthy company.
Blue-sky laws State laws covering the issue and trading
of securities.
Boilerplate Standard terms and conditions, e.g., in a debt
contract.
Bond Long-term debt.
Bookbuilding The procedure whereby underwriters
gather nonbinding indications of demand for a new issue.
Book entry System whereby only one global certificate is
issued for bond and evidence of ownership is receipt
showing interest in this certificate.
Book runner The managing underwriter for a new issue.
The book runner maintains the book of securities sold.
Bought deal Security issue where one or two underwriters
buy the entire issue.
bp Basis point.
Bracket A term signifying the extent of an underwriter’s
commitment in a new issue, e.g., major bracket, minor
bracket.
Break-even analysis Analysis of the level of sales at which
a project would just break even.
Bridging loan Short-term loan to provide temporary
financing until more permanent financing is arranged.
Bull–bear bond Bond whose principal repayment is linked
to the price of another security. The bonds are issued in
two tranches: In the first the repayment increases with the
price of the other security; in the second the repayment
decreases with the price of the other security.
Bulldog bond Foreign bond issue made in London.
Bullet payment Single final payment, e.g., of a loan (in
contrast to payment in installments).
Bull market Widespread rise in security prices (cf. bear
market).
Buy-back Repurchase agreement.
C
Cable The exchange rate between U.S. dollars and
sterling.
Call option Option to buy an asset at a specified
exercise price on or before a specified exercise date
(cf. put option).
Call premium (1) Difference between the price at which a
company can call its bonds and their face value; (2) price of
an option.
Call provision Provision that allows an issuer to buy back
the bond issue at a stated price.
Cap An upper limit on the interest rate on a floating-rate
note.
Capital budget List of planned investment projects,
usually prepared annually.
Capitalization Long-term debt plus preferred stock plus net
worth.
Capital lease Financial lease.
Capital market Financial market (particularly the market
for long-term securities).
Capital rationing Shortage of funds that forces a
company to choose between worthwhile projects.
Capital structure Mix of different securities issued by a firm.
CAPM Capital asset pricing model.
CAR Cumulative abnormal return.
CARDs (Certificates for Amortizing Revolving Debt) Pass-
through securities backed by credit card receivables.
CARs (Certificates of Automobile Receivables) Pass-
through securities backed by automobile receivables.
Carve-out Public offering of shares in a subsidiary.
Cascade Rational herding in which each individual
deduces that previous decisions by others may have been
based on extra information.
Cash and carry Purchase of a security and simultaneous
sale of a future, with the balance being financed with a
loan or repo.
Cash budget Forecast of sources and uses of cash.
Cash-deficiency arrangement Arrangement whereby a
project’s shareholders agree to provide the operating
company with sufficient net working capital.
CAT bond Catastrophe bond.
Catastrophe bond (CAT bond) Bond whose payoffs are
linked to a measure of catastrophe losses such as
insurance claims.
CD Certificate of deposit.
Certainty equivalent A certain cash flow that has the
same present value as a specified risky cash flow.
1040 GLOSSARY
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Glossary
© The McGraw−Hill
Companies, 2003
Certificate of deposit (CD) A certificate providing
evidence of a bank time deposit.
CFTC Commodity Futures Trading Commission.
CFO Chief financial officer.
Chaebol A Korean conglomerate.
CHIPS Clearing House Interbank Payments System.
Clean price (flat price) Bond price excluding accrued
interest (cf. dirty price).
Clearing House Interbank Payments System (CHIPS) An
international wire transfer system operated by a group of
major banks for high-value dollar payments.
Closed-end mortgage Mortgage against which no addi-
tional debt may be issued (cf. open-end mortgage).
CMOs Collateralized mortgage obligations.
Collar An upper and lower limit on the interest rate on a
floating-rate note.
Collateral Assets that are given as security for a loan.
Collateralized mortgage obligations (CMOs) A variation
on the mortgage pass-through security, in which the cash
flows from a pool of mortgages are repackaged into
several tranches of bonds with different maturities.
Collateral trust bonds Bonds secured by common stocks or
other securities that are owned by the borrower.
Collection float Customer-written checks that have not
been received, deposited, and added to the company’s
available balance (cf. payment float).
Commercial draft (bill of exchange) Demand for payment.
Commercial paper Unsecured notes issued by companies
and maturing within nine months.
Commitment fee Fee charged by bank on an unused line
of credit.
Common stock Security representing ownership of a
corporation.
Compensating balance Non-interest-bearing demand
deposits to compensate banks for bank loans or services.
Competitive bidding Means by which public utility
holding companies are required to choose their underwriter
(cf. negotiated underwriting).
Completion bonding Insurance that a construction
contract will be successfully completed.
Compound interest Reinvestment of each interest payment
on money invested to earn more interest (cf. simple interest).
Compound option Option on an option.
Concentration banking System whereby customers
make payments to a regional collection center. The
collection center pays the funds into a regional bank
account and surplus money is transferred to the
company’s principal bank.
Conditional sale Sale in which ownership does not pass
to the buyer until payment is completed.
Conglomerate merger Merger between two companies in
unrelated businesses (cf. horizontal merger, vertical merger).
Consol Name of a perpetual bond issued by the British
government. Sometimes used as a general term for
perpetuity.
Contango Condition in which spot price of a commodity
is below that of the future (cf. backwardation).
Contingent claim Claim whose value depends on the
value of another asset.
Contingent project Project that cannot be undertaken
unless another project is also undertaken.
Continuous compounding Interest compounded continu-
ously rather than at fixed intervals.
Controller Officer responsible for budgeting, accounting,
and auditing in a firm (cf. treasurer).
Convenience yield The extra advantage that firms derive
from holding the commodity rather than the future.
Conversion price Par value of a convertible bond divided by
the number of shares into which it may be exchanged.
Conversion ratio Number of shares for which a convertible
bond may be exchanged.
Convertible bond Bond that may be converted into
another security at the holder’s option. Similarly convert-
ible preferred stock.
Convexity Term often used to describe the fact that the
effect of an interest rate change on bond prices declines as
the interest rate rises.
Correlation coefficient Measure of the closeness of the
relationship between two variables.
Cost company arrangement Arrangement whereby the
shareholders of a project receive output free of charge but
agree to pay all operating and financing charges of the
project.
Cost of capital Opportunity cost of capital.
Coupon (1) Specifically, an attachment to the certificate of a
bearer security that must be surrendered to collect interest
payment; (2) more generally, interest payment on debt.
Covariance Measure of the comovement between two
variables.
Covenant Clause in a loan agreement.
Credit derivative Contract for hedging against loan
default or changes in credit risk (see default swap, credit
option).
Credit option Similar to a long-term insurance policy
against loan default.
Credit scoring A procedure for assigning scores to
borrowers on the basis of the risk of default.
Cross-default clause Clause in a loan agreement stating
that the company is in default if it fails to meet its obliga-
tion on any other debt issue.
Cum dividend With dividend.
Cum rights With rights.
Cumulative preferred stock Stock that takes priority over
common stock in regard to dividend payments. Dividends
GLOSSARY 1041
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
Back Matter Glossary
© The McGraw−Hill
Companies, 2003
may not be paid on the common stock until all past
dividends on the preferred stock have been paid.
Cumulative voting Voting system under which a stock-
holder may cast all of his or her votes for one candidate
for the board of directors (cf. majority voting).
Current asset Asset that will normally be turned into
cash within a year.
Current liability Liability that will normally be repaid
within a year.
Current ratio Current assets divided by current liabilities—
a measure of liquidity.
D
DCF Discounted cash flow.
Debenture Unsecured bond.
Decision tree Method of representing alternative sequen-
tial decisions and the possible outcomes from these
decisions.
Default swap Credit derivative in which one party makes
fixed payments while the payments by the other party
depend on the occurrence of a loan default.
Defeasance Practice whereby the borrower sets aside
cash or bonds sufficient to service the borrower’s debt.
Both the borrower’s debt and the offsetting cash or bonds
are removed from the balance sheet.
Delta Hedge ratio.
Depository transfer check (DTC) Check made out directly
by a local bank to a particular company.
Depreciation (1) Reduction in the book or market value
of an asset; (2) portion of an investment that can be
deducted from taxable income.
Derivative Asset whose value derives from that of some
other asset (e.g., a future or an option).
Diff Differential swap.
Differential swap (diff, quanto swap) Swap between two
LIBOR rates of interest, e.g., yen LIBOR for dollar LIBOR.
Payments are in one currency.
Dilution Diminution in the proportion of income to
which each share is entitled.
Direct lease Lease in which the lessor purchases new
equipment from the manufacturer and leases it to the
lessee (cf. sale and lease-back).
Direct quote For foreign exchange, the number of U.S.
dollars needed to buy one unit of a foreign currency (cf.
indirect quote).
Dirty price Bond price including accrued interest, i.e., the
price paid by the bond buyer (cf. clean price).
Discount bond Debt sold for less than its principal value.
If a discount bond pays no interest, it is called a “pure”
discount, or zero-coupon, bond.
Discounted cash flow (DCF) Future cash flows multiplied
by discount factors to obtain present value.
Discount factor Present value of $1 received at a stated
future date.
Discount rate Rate used to calculate the present value of
future cash flows.
Discriminatory price auction Auction in which successful
bidders pay the price that they bid (cf. uniform price
auction).
Disintermediation Withdrawal of funds from a
financial institution in order to invest them directly
(cf. intermediation).
Dividend Payment by a company to its stockholders.
Dividend reinvestment plan (DRIP) Plan that allows share-
holders to reinvest dividends automatically.
Dividend yield Annual dividend divided by share price.
Double-declining-balance depreciation Method of acceler-
ated depreciation.
Double-tax agreement Agreement between two countries
that taxes paid abroad can be offset against domestic taxes
levied on foreign dividends.
Down-and-in option Barrier option that comes into
existence if asset price hits a barrier.
Down-and-out option Barrier option that expires if asset
price hits a barrier.
DRIP Dividend reinvestment plan.
Drop lock An arrangement whereby the interest rate on
a floating-rate note or preferred stock becomes fixed if it falls
to a specified level.
DTC Depository transfer check.
Dual-currency bond Bond with interest paid in one
currency and principal paid in another.
Duration The average number of years to an asset’s
discounted cash flows.
E
EBIT Earnings before interest and taxes.
Economic exposure Risk that arises from changes in real
exchange rates (cf. transaction exposure, translation
exposure).
Economic income Cash flow plus change in present value.
Economic rents Profits in excess of the competitive level.
Economic Value Added (EVA) A measure of residual income
implemented by the consulting firm Stern Stewart.
Efficient market Market in which security prices reflect
information instantaneously.
Efficient portfolio Portfolio that offers the lowest risk
(standard deviation) for its expected return and the highest
expected return for its level of risk.
Employee stock ownership plan (ESOP) A company
contributes to a trust fund that buys stock on behalf of
employees.
EPS Earnings per share.
1042 GLOSSARY