Financial theory and corporate policy [Hauptbd.]

925 Pages·4.731 MB·English

by  Copeland, Thomas E;Weston, J Fred;Shastri, Kuldeep

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i Financial Theory and Corporate Policy
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Thomas E. Copeland
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J. Fred Weston Kuldeep Shastri
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Fourth Edition
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ISBN 978-1-29202-158-4 4
e
9 781292 021584
Financial Theory and Corporate Policy
Thomas E. Copeland
J. Fred Weston Kuldeep Shastri
Fourth Edition
ISBN 10: 1-292-02158-6
ISBN 13: 978-1-292-02158-4
Pearson Education Limited
Edinburgh Gate
Harlow
Essex CM20 2JE
England and Associated Companies throughout the world
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© Pearson Education Limited 2014
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book by such owners.
ISBN 10: 1-292-02158-6
ISBN 13: 978-1-292-02158-4
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Printed in the United States of America
112333441479495057161577315335339
P E A R S O N C U S T O M L I B R AR Y
Table of Contents
1. Introduction: Captial Markets, Consumption, and Investment
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 1
2. Investment Decisions: The Certainty Case
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 15
3. Theory of Choice Under Uncertainty: Utility Theory
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 43
4. State Preference Theory
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 73
5. Objects of Choice
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 99
6. Market Equilibrium: CAPM and APT
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 145
7. Pricing Contingent Claims: Option Price Theory and Evidence
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 197
8. Futures Contracts and Markets - Term Structure - Cox, Ingersoll, Ross
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 257
9. Multiperiod Capital Budgeting under Uncertainty: Real Options Analysis
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 303
10. Efficient Captial Markets: Theory
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 351
11. Efficient Captial Markets: Evidence
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 375
12. Information Asymmetry and Agency Theory
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 413
13. Valuation and Tax Policy
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 463
I
566778888921618345703139513957
14. Capital Structure and the Cost of Capital: Theory and Evidence
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 523
15. Dividend Policy: Theory and Empirical Evidence
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 611
16. Applied Issues in Corporate Finance
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 663
17. Acquisitions, Divestitures, Restructuring, and Corporate Governance
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 719
18. International Financial Management
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 785
Appendix: Discounting
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 831
Appendix: Matrix Algebra
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 843
Appendix: An Introduction to Multiple Regression
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 859
Appendix: Calculus and Optimization
Thomas E. Copeland/J. Fred Weston,/Kuldeep Shastri 875
Index 907
II
. . . Throughthealterationsin
theincomestreamsprovided
Introduction:
byloansorsales,themarginal
degreesofimpatienceforall
Capital Markets,
individualsinthemarketare
broughtintoequalitywitheach
Consumption,
otherandwiththemarketrate
ofinterest.
and Investment
—IrvingFisher,
TheTheoryofInterest, Macmillan,
NewYork,1930,122.
I
A. ntroduction
T
HEOBJECTIVEOFTHISCHAPTERistostudyconsumptionandinvestmentdecisions
madebyindividualsandfirmsandtounderstandtheroleofinterestratesinmakingthese
decisions. The decision about what projects to undertake and which to reject is perhaps
thesinglemostimportantdecisionthatafirmcanmake.Logicaldevelopmentisfacilitatedifwe
beginwiththesimplestofallworlds,aone-person/one-goodeconomywithnouncertainty.The
decision maker, Robinson Crusoe, must choose between consumption now and consumption in
thefuture.Ofcourse,thedecisionnottoconsumenowisthesameasinvestment.ThusRobinson
Crusoe’s decision is simultaneously one of consumption and investment. In order to decide, he
needstwotypesofinformation.First,heneedstounderstandhisownsubjectivetrade-offsbetween
consumptionnowandconsumptioninthefuture.Thisinformationisembodiedintheutilityand
indifference curves depicted in Figs. 1 through 3. Second, he must know the feasible trade-
offsbetweenpresentandfutureconsumptionthataretechnologicallypossible.Thesearegivenin
theinvestmentandproductionopportunitysetsofFigs.4and5.
From the analysis of a Robinson Crusoe economy we will find that the optimal consump-
tion/investment decision establishes a subjective interest rate for Robinson Crusoe. Shown in
Fig. 5, it represents his (unique) optimal rate of exchange between consumption now and in
thefuture.Thusinterestratesareanintegralpartofconsumption/investmentdecisions.Onecan
thinkoftheinterestrateasthepriceofdeferredconsumptionortherateofreturnoninvestment.
Individualshavingdifferentsubjectiveinterestrates(showninFig.6)willselectdifferentcon-
sumption/investmentchoices.AftertheRobinsonCrusoeeconomywewillintroduceopportunities
toexchangeconsumptionacrosstimebyborrowingorlendinginamultipersoneconomy(shown
in Fig. 7). The introduction of these exchange opportunities results in a single market inter-
estratethateveryonecanuseasasignalformakingoptimalconsumption/investmentdecisions
From Chapter 1 of Financial Theory and Corporate Policy, Fourth Edition. Thomas E. Copeland, J. Fred Weston, Kuldeep
Shastri. Copyright © 2005 by Pearson Education, Inc. All rights reserved.
1
Introduction:CapitalMarkets,Consumption,andInvestment
(Fig.8).Furthermore,nooneisworseoffinanexchangeeconomywhencomparedwithaRobin-
sonCrusoeeconomy,andalmosteveryoneisbetteroff(Fig.9).Thusanexchangeeconomythat
usesmarketprices(interestrates)toallocateresourcesacrosstimewillbeseentobesuperiorto
aneconomywithoutthepricemechanism.
Theobviousextensiontotheintroductorymaterialinthischapteristheinvestmentdecisions
madebyfirmsinamultiperiodcontext.Managersneedoptimaldecisionstohelpinselectingthose
projectsthatmaximizethewealthofshareholders.Weshallseethatmarket-determinedinterest
ratesplayanimportantroleinthecorporateinvestmentandproductiondecisions.
C
B. onsumption and Investment without Capital Markets
The answer to the question “Do capital markets benefit society?” requires that we compare a world
without capital markets to one with them and show that no one is worse off and that at least one
individual is better off in a world with capital markets. To make things as simple as possible, we
assume that all outcomes from investment are known with certainty, that there are no transaction
costs or taxes, and that decisions are made in a one-period context. Individuals are endowed with
income (manna from heaven) at the beginning of the period, y , and at the end of the period, y .
0 1
They must decide how much to actually consume now,C , and how much to invest in productive
0
opportunities in order to provide end-of-period consumption,C . Every individual is assumed to
1
prefer more consumption to less. In other words, the marginal utility of consumption is always
positive. Also, we assume that the marginal utility of consumption is decreasing. The total utility
curve (Fig. 1) shows the utility of consumption at the beginning of the period, assuming that
the second-period consumption is held constant. Changes in consumption have been marked off
in equal increments along the horizontal axis. Note that equal increases in consumption cause
total utility to increase (marginal utility is positive), but that the increments in utility become
smaller and smaller (marginal utility is decreasing). We can easily construct a similar graph to
represent the utility of end-of-period consumption, U(C ). When combined with Fig. 1, the
1
result(thethree-dimensionalgraphshowninFig.2)providesadescriptionoftrade-offsbetween
Figure1 Totalutility Total utility = U(C )
0
ofconsumption.
Consumption, C
0
2
Introduction:CapitalMarkets,Consumption,andInvestment
Figure 2 Trade-offs U(C ,C )
0 1 U(C )
betweenbeginning 1
andend-of-period
consumption.
A
B
C
1
U(C )
0
C
0
consumptionatthebeginningoftheperiod,C ,andconsumptionattheendoftheperiod,C .The
0 1
dashed lines represent contours along the utility surface where various combinations of C and
0
C provide the same total utility (measured along the vertical axis). Since all points along the
1
samecontour(e.g.,pointsAandB)haveequaltotalutility,theindividualwillbeindifferentwith
respecttothem.Thereforethecontoursarecalledindifferencecurves.LookingatFig.2from
above,wecanprojecttheindifferencecurvesontotheconsumptionargumentplane(i.e.,theplane
formedbytheC ,andC axesinFig.3).Toreiterate,allcombinationsofconsumptiontoday
0 1
and consumption tomorrow that lie on the same indifference curve have the same total utility.
The decision maker whose indifference curves are depicted in Fig. 3 would be indifferent as
to point A with consumption (C0a,C1a) and point B with consumption (C0b,C1b). Point A has
more consumption at the end of the period but less consumption at the beginning than point B
does.PointDhasmoreconsumptioninbothperiodsthandoeitherpointsAorB.PointDlieson
anindifferencecurvewithhigherutilitythanpointsAandB;hencecurvestothenortheasthave
greatertotalutility.TheslopeofthestraightlinejusttangenttotheindifferencecurveatpointB
measurestherateoftrade-offbetweenC andC atpointB.Thistrade-offiscalledthemarginal
0 1
rateofsubstitution(MRS)betweenconsumptiontodayandconsumptiontomorrow.Italsoreveals
howmanyextraunitsofconsumptiontomorrowmustbereceivedinordertogiveuponeunitof
consumptiontodayandstillhavethesametotalutility.Mathematicallyit’sexpressedas1
(cid:2)
∂C (cid:2)
MRSCC01= ∂C01(cid:2)(cid:2)U=const.=−(1+ri). (1)
1Equation (1) can be read as follows: The marginal rate of substitution between consumption today and end-of-
(cid:3)p∂eCrio1d(cid:4)∂coCn0s(cid:5)um(cid:2)(cid:2)Up=tcioonns,t.M. TRhSiCCs01i,nistuernquiasletqouathletosltohpeeinodfivaidliunael’tsasnugbejnetcttioveanraitnedoifffteirmenecperecfuerrveencgei,v−en(1co+nsrtia)n.ttotalutility
3
Introduction:CapitalMarkets,Consumption,andInvestment
Figure3 Indifference C
1
curves representing
the time preference of
consumption.
C A D
1a
C B
1b
C
C C 0
0a 0b
Figure 4 An indi- Marginal
vidual’s schedule of rate of return
productive investment
A
opportunities.
r B
i
X
I Total investment
0
Note that the subjective rate of time preference is greater at point A than at point B due to the
convexityoftheindifferencecurve.TheindividualhaslessconsumptiontodayatpointAandwill
thereforedemandrelativelymorefutureconsumptioninordertohavethesametotalutility.
Thusfarwehavedescribedpreferencefunctionsthattellushowindividualswillmakechoices
among consumption bundles over time. What happens if we introduce productive opportunities
that allow a unit of current savings/investment to be turned into more than one unit of future
consumption? We assume that each individual in the economy has a schedule of productive
investmentopportunitiesthatcanbearrangedfromthehighestrateofreturndowntothelowest
(Fig.4).Althoughwehavechosentographtheinvestmentopportunitiesscheduleasastraight
line,anydecreasingfunctionwoulddo.Thisimpliesdiminishingmarginalreturnstoinvestment
because the more an individual invests, the lower the rate of return on the marginal investment.
Also,allinvestmentsareassumedindependentofoneanotherandperfectlydivisible.
An individual will make all investments in productive opportunities that have rates of return
higher than his or her subjective rate of time preference, ri. This can be demonstrated if we
4
Introduction:CapitalMarkets,Consumption,andInvestment
Figure5 Theproduc- C
1
tionopportunityset.
X
P = C B
1 1
U
2
y1 U1
Slope = – (1 + r)
i
A
C
P = C y 0
0 0 0
transform the schedule of productive investment opportunities into the consumption argument
plane(Fig.5).2TheslopeofalinetangenttocurveABXinFig.5istherateatwhichadollarof
consumptionforegonetodayistransformedbyproductiveinvestmentintoadollarofconsumption
tomorrow.Itisthemarginalrateoftransformation(MRT)offeredbytheproduction/investment
opportunity set. The line tangent to point A has the highest slope in Fig. 5 and represents the
highestrateofreturnatpointAinFig.4.Anindividualendowedwitharesourcebundle(y ,y )
0 1
thathasutilityU canmovealongtheproductionopportunitysettopointB,wheretheindifference
1
curveistangenttoitandheorshereceivesthemaximumattainableutility,U .Becausecurrent
2
consumption,C ,islessthanthebeginning-of-periodendowment,y ,theindividualhastoinvest.
0 0
Theamountofinvestmentisy −C .Ofcourse,ifC >y ,heorshewilldisinvest.
0 0 0 0
Notethatthemarginalrateofreturnonthelastinvestmentmade(i.e.,MRT,theslopeofaline
tangenttotheinvestmentopportunitysetatpointB)isexactlyequaltotheinvestor’ssubjective
timepreference(i.e.,MRS,theslopeofalinetangenttohisorherindifferencecurve,alsoatpoint
B).Inotherwords,theinvestor’ssubjectivemarginalrateofsubstitutionisequaltothemarginal
rateoftransformationofferedbytheproductionopportunityset:
MRS=MRT.
This will also be true in a Robinson Crusoe world where there are no capital markets (i.e., no
opportunitiestoexchange).Theindividualdecisionmakerstartswithaninitialendowment(y ,y )
0 1
andcomparesthemarginalrateofreturnonadollarofproductiveinvestment(ordisinvestment)
withhisorhersubjectivetimepreference.Iftherateoninvestmentisgreater(asitisinFig.5),
heorshewillgainutilitybymakingtheinvestment.Thisprocesscontinuesuntiltherateofreturn
on the last dollar of productive investment just equals the rate of subjective time preference (at
pointB).NotethatatpointBtheindividual’sconsumptionineachtimeperiodisexactlyequalto
theoutputfromproduction(i.e.,P =C andP =C ).
0 0 1 1
Withouttheexistenceofcapitalmarkets,individualswiththesameendowmentandthesamein-
vestmentopportunitysetmaychoosecompletelydifferentinvestmentsbecausetheyhavedifferent
2SeeProblem6attheendofthechapterforanexampleofhowtomakethetransitionbetweenthescheduleofproductive
investmentopportunitiesandtheconsumptionargumentplane.
5