Principles of Corporate Finance
This was the book I first learned finance from as an undergrad at Oxford, and all new analysts were given it at Morgan Stanley, so it’s an honor to now be a coauthor. But while the book has been a standard for decades, it needs to evolve. Here’s what we’ve tried to improve:
- Standard finance theory focuses on shareholder value. We take seriously the idea that a CEO should promote the interests of all stakeholders, and analyze whether/when to depart from the NPV tool that’s been taught forever (if so, what to replace it with; but also when NPV works fine). We’ve devoted an entire new chapter to Responsible Business. But, it’s not just something that can be pigeon-holed into a single chapter; it pervades the whole book. Out of the five principles that governed prior editions, we’ve rewritten #2 to stress that managers consider “the long-term consequences of all decisions, including their effects on stakeholders such as customers, employees, and the environment”.
- The chapter on Corporate Governance – who a CEO runs a company for and the mechanisms to ensure it’s run in the right way – has similarly been substantially rewritten.
- The chapter on Market Efficiency has been overhauled. It takes much more seriously behavioral finance, evidence for behavioral biases, and challenges to the Efficient Markets Hypothesis.
- Modern finance is advancing due to AI, big data, and cloud computing. We analyse seven ways in which FinTech is changing financial practice.
- A U.S. financial manager works in a global environment, so s/he needs to understand the financial systems of other countries. Also, many readers are non-US. The 14th edition is much more global, including information about major developing economies.
- In addition to the content, we’ve made pedagogical changes throughout. The material is much more clearly explained and easier to understand – importantly, without dumbing it down. It’s been tightened, not loosened – terms are precisely defined and definitions are less hand-wavy. We include end-of-chapter summaries to make the takeaways clearer, and include self-test questions (with answers) so that readers can check their understanding.
The Do-It-Yourself (DIY) Principle: A company can never add value by achieving outcomes that shareholders can achieve costlessly themselves.
The Time Value Principle: A dollar today is worth more than a dollar tomorrow because it can be invested to earn a return.
The Risk Principle: A safe dollar is worth more than a risky dollar.
The Discount Rate Principle: The discount rate for a project is the opportunity cost of investing in that project, which depends on the risk of that project. It does not depend on the cost of capital or risk of the company undertaking the project.
The Price-Yield Principle: The higher the yield on a bond, the lower its price.
The Market Value Principle: In almost all financial applications, use market values rather than book values.
The Forward-Looking Principle: Cash flows and discount rates should reflect what is expected to happen in the future, not what has happened in the past.
The Growth Principle: Growth only adds value to a company if the rate of return on reinvested capital exceeds the cost of capital.
The Stable Risk Premium Principle: When forecasting future market returns, it is more realistic to assume a stable market risk premium than a stable market return.
The Diversification Principle: The standard deviation of a portfolio is lower than the average standard deviation of the stocks in that portfolio, because diversification reduces risk.
The Limits to Diversification Principle: You can only diversify away specific risk, not systematic risk.
The Common Portfolio Principle: If all investors have the same information and form the same expectations, all should hold the same portfolio of stocks.
The Portfolio Beta Principle: The beta of a portfolio is the weighted average of the betas of the stocks in that portfolio.
The Systematic Risk Principle: The cost of capital is only affected by systematic risk, not specific risk.
The Downside Risk Principle: Downside risk should always be incorporated by reducing expected cash flows, not by adding fudge factors into the discount rate. The discount rate depends only on systematic risk, and is unaffected if the downside risk is idiosyncratic.
The Market Prices Principle: Wherever possible, use market prices to check either your assumptions or the valuations that result from your assumptions.
The Replication Principle: Any set of contingent payoffs—that is, payoffs that depend on the value of some other asset—can be replicated with a mixture of simple options on that asset.
The Project Leverage Principle: The leverage used when calculating the discount rate for a project should depend on the project’s debt capacity, not how the project is initially financed.
The Currency Risk Principle: When evaluating international investment opportunities, ignore currency risk if it can be hedged.
The Investors’ Portfolio Principle: The cost of capital for an international investment depends on its beta relative to your investors’ portfolio, not where your investors are located nor where the investment is located.
The Country Risk Principle: Country risk should be incorporated by adjusting expected cash flows, not by adding a fudge factor such as a “country risk premium” to the discount rate.
The Synergy Principle: A merger only creates synergies if it achieves outcomes that the merging companies, or their shareholders, could not achieve themselves.