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Table of Contents vii

4.9 The Role of Financial Ratios—and a Final Note Expectations Theory 201
on Transparency 121 Interest Rate Risk and the Liquidity Premium 202
Transparency 122
6.6 Corporate Bonds and the Risk of Default 203
4.10 Summary 123 Variations in Corporate Bonds 206
6.7 Summary 209
PART TWO
Appendix 6A: A More Detailed Look at the Yield
VALUE 131 Curve 216
Appendix 6B: Duration: Measuring the Life of a Bond
CHAPTER 5
(available on Connect)
The Time Value of Money 131

5.1 Future Values and Compound Interest 132 CHAPTER 7

Valuing Stocks 219
5.2 Present Values 136
Finding the Interest Rate 140 7.1 Stocks and Stock Markets 220
Finding the Investment Period 141 Reading Stock Market Listings 222
5.3 Multiple Cash Flows 142 7.2 Market Values, Book Values, and Liquidation
Future Value of Multiple Cash Flows 142 Values 225
Present Value of Multiple Cash Flows 145
7.3 Valuing Common Stocks 228
5.4 Level Cash Flows: Perpetuities and Annuities 147 Valuation by Comparables 228
How to Value Perpetuities 147 Price and Intrinsic Value 229
How to Value Annuities 149 The Dividend Discount Model 231
Annuities Due 153
Future Value of an Annuity 155 7.4 Simplifying the Dividend Discount Model 234
Cash Flows Growing at a Constant Rate—Variations The Dividend Discount Model with No Growth 234
on Perpetuities and Annuities 158 The Constant-Growth Dividend Discount Model 235
Estimating Expected Rates of Return 237
5.5 Inflation and the Time Value of Money 160 Non-Constant Growth 238
Real versus Nominal Cash Flows 160
Inflation and Interest Rates 162 7.5 Growth Stocks and Income Stocks 240
Valuing Real Cash Payments 164 7.6 There are No Free Lunches on Bay Street 243
Real or Nominal? 165 Method 1: Technical Analysis 244
5.6 Effective Annual Interest Rates 165 Method 2: Fundamental Analysis 247
A Theory to Fit the Facts 248
5.7 Summary 168
7.7 Market Anomalies and Behavioural Finance 249
CHAPTER 6 Market Anomalies 249
Valuing Bonds 182 Behavioural Finance 250
7.8 Summary 251
6.1 Bonds and the Bond Market 184
Bond Market Data 184
CHAPTER 8
6.2 Interest Rates and Bond Prices 186 Net Present Value and Other Investment
How Bond Prices Vary with Interest Rates 188 Criteria 262
6.3 Current Yield and Yield to Maturity 190
8.1 Net Present Value 264
6.4 Bond Rates of Return 192 A Comment on Risk and Present Value 265
Taxes and Rates of Return 196 Valuing Long-Lived Projects 265
Multiperiod Rates of Return 197 Using the NPV Rule to Choose Among Projects 269
6.5 The Yield Curve 198 8.2 Other Investment Criteria 269
Nominal and Real Rates of Interest 199 Payback 270
The Determinants of the Yield Curve 201 Discounted Payback 271
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viii Table of Contents

Internal Rate of Return 272 CHAPTER 10

A Closer Look at the Rate of Return Rule 274 Project Analysis 333
Calculating the Rate of Return for Long-Lived
Projects 274 10.1 How Firms Organize the Investment
A Word of Caution 277 Process 334
Some Pitfalls of the IRR Rule 277 Stage 1: The Capital Budget 335
Stage 2: Project Authorizations 335
8.3 More Examples of Mutually Exclusive Problems and Some Solutions 336
Projects 281
Investment Timing 282 10.2 Some “What If” Questions 337
Long-versus Short-Lived Equipment 283 Sensitivity Analysis 337
Replacing an Old Machine 285 Scenario Analysis 340
8.4 Capital Rationing 286 10.3 Break-Even Analysis 341
Soft Rationing 286 Accounting Break-Even Analysis 341
Hard Rationing 286 NPV Break-Even Analysis 343
Pitfalls of the Profitability Index 288 Operating Leverage 346
8.5 A Last Look 288 10.4 Real Options and the Value of Flexibility 348
8.6 Summary 289 The Option to Expand 348
A Second Real Option: The Option to
CHAPTER 9 Abandon 350
Using Discounted Cash Flow Analysis to Make A Third Real Option: The Timing Option 351
Investment Decisions 299 A Fourth Real Option: Flexible Production
Facilities 352
9.1 Identifying Cash Flows 301
10.5 Summary 352
Discount Cash Flows, Not Profits 301
Discount Incremental Cash Flows 303
Include All Indirect Effects 303 PART THREE
Forget Sunk Costs 303
Include Opportunity Costs 304
RISK 360
Recognize the Investment in Working Capital 304
Remember Shutdown Cash Flows 305 CHAPTER 11
Beware of Allocated Overhead Costs 305 Introduction to Risk, Return, and the
Discount Nominal Cash Flows by the Nominal Cost Opportunity Cost of Capital 360
of Capital 306
Separate Investment and Financing Decisions 307 11.1 Rates of Return: A Review 361

9.2 Calculating Cash Flows 307 11.2 Eighty-Five Years of Capital Market
Capital Investment 308 History 363
Investment in Working Capital 308 Market Indexes 363
Operating Cash Flow 309 The Historical Record 364
Using Historical Evidence to Estimate Today’s Cost
9.3 Business Taxes in Canada and the Capital
of Capital 367
Budgeting Decision 311
Depreciation and Capital Cost Allowance 311 11.3 Measuring Risk 369
The Asset Class System 312 Variance and Standard Deviation 369
Sale of Assets 314 A Note on Calculating Variance 372
Termination of Asset Pool 314 Measuring the Variation in Stock Returns 372
Present Values of CCA Tax Shields 315
11.4 Risk and Diversification 374
9.4 Example: Blooper Industries 317 Diversification 374
Calculating Blooper’s Project Cash Flows 318 Asset versus Portfolio Risk 375
Calculating the NPV of Blooper’s Project 320 Covariance and Correlation 378
Further Notes and Wrinkles Arising from Blooper’s Correlation and Portfolio Diversification 379
Project 321 Market Risk versus Unique Risk 382
9.5 Summary 324 11.5 Thinking About Risk 383
Appendix 9A: Deriving the CCA Tax Shield Message 1: Some Risks Look Big and Dangerous but
(available on Connect) Really are Diversifiable 383
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Table of Contents ix

Message 2: Market Risks are Macro Risks 384 How Changing Capital Structure Affects WACC
Message 3: Risk Can be Measured 385 When the Corporate Tax Rate is Zero 436
How Changing Capital Structure Affects Debt and
11.6 Summary 385
Equity when the Corporate Tax Rate is Zero 437
What Happens if Capital Structure Changes and the
CHAPTER 12 Corporate Tax Rate is Not Zero? 438
Risk, Return, and Capital Budgeting 392 Revisiting the Project Cost of Capital 440

12.1 Measuring Market Risk 393 13.7 Valuing Entire Businesses 440
Measuring Beta 394 Calculating the Value of the Concatenator
Betas for Cameco and Royal Bank 397 Business 442
Total Risk and Market Risk 398 13.8 Summary 443
Portfolio Betas 399
12.2 Risk and Return and Capital Asset Pricing PART FOUR
Model, CAPM 400
Why the CAPM Makes Sense 403 FINANCING 451
The Security Market Line 404
How Well Does the CAPM Work? 405 CHAPTER 14
Using the CAPM to Estimate Expected Returns 408 Introduction to Corporate Financing and
Governance 451
12.3 Capital Budgeting and Project Risk 408
Company Risk versus Project Risk 409 14.1 Creating Value with Financing Decisions 453
Determinants of Project Risk 410
Don’t Add Fudge Factors to Discount Rates 411 14.2 Common Stock 454
Book Value versus Market Value 455
12.4 Summary 412
Dividends 456
Ownership of the Corporation 456
CHAPTER 13 Voting Procedures 456
The Weighted-Average Cost of Capital and Classes of Stock 457
Company Valuation 420 Corporate Governance in Canada and
Elsewhere 458
13.1 Geothermal’s Cost of Capital 421
14.3 Preferred Stock 461
13.2 The Weighted-Average Cost of Capital 423
Calculating Company Cost of Capital as a Weighted 14.4 Corporate Debt 463
Average 424 Debt Comes in Many Forms 463
Use Market Weights, Not Book Weights 426 Innovation in the Debt Market 468
Taxes and the Weighted-Average Cost 14.5 Convertible Securities 472
of Capital 427
What If There are Three (or More) Sources 14.6 Patterns of Corporate Financing 473
of Financing? 428 Do Firms Rely Too Heavily on Internal Funds? 474
Wrapping Up Geothermal 428 External Sources of Capital 474
Checking Our Logic 429 14.7 Summary 476
13.3 Measuring Capital Structure 430 Appendix 14A: The Bond Refunding Decision 481
13.4 Calculating Required Rates of Return 432
The Expected Return on Bonds 432 CHAPTER 15
The Expected Return on Common Stock 432 Venture Capital, IPOs, and Seasoned
The Expected Return on Preferred Stock 434 Offerings 488
13.5 Calculating the Weighted-Average Cost
15.1 Venture Capital 490
of Capital 434
Venture Capital Companies 491
Real Company WACC 435
15.2 The Initial Public Offering 492
13.6 Interpreting the Weighted-Average Cost
Arranging a Public Issue 493
of Capital 435
When You Can and Can’t Use WACC 435 15.3 The Underwriters 497
Some Common Mistakes 436 Who are the Underwriters? 498
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x Table of Contents

15.4 Listing on the Stock Market 500 CHAPTER 17

15.5 Rights Issues and General Cash Offers by Public
Leasing 560
Companies 501
17.1 What is a Lease? 561
Rights Issues 501
Leasing Industry 562
General Cash Offers 503
Costs of the General Cash Offer 504 17.2 Why Lease? 563
Market Reaction to Stock Issues 504 Sensible Reasons for Leasing 563
Some Dubious Reasons for Leasing 564
15.6 The Private Placement 505
17.3 Valuing Leases 567
15.7 Summary 506
Operating Leases 567
Appendix 15A: The Financing of New and Small Financial Leases 568
Enterprises 512 Cash Flows of a Financial Lease 568
Who Really Owns the Leased Asset? 570
Other Sources of Small Business Financing 517
Leasing and the Canada Revenue Agency (CRA) 571
Appendix 15B: Hotch Pot’s New Issue Prospectus 519 First Pass at Valuing a Financial Lease Contract 571
Financial Lease Evaluation 574
PART FIVE Using Formulas to Evaluate Financial Leases 574

DEBT AND PAYOUT POLICY 523 17.4 When Do Financial Leases Pay? 576
17.5 Summary 577
CHAPTER 16
Debt Policy 523 CHAPTER 18
Payout Policy 584
16.1 How Borrowing Affects Value in a Tax-Free
Economy 525
18.1 How Dividends are Paid 585
MM’s Argument 526
Cash Dividends 585
How Borrowing Affects Earnings per Share 526
Some Legal Limitations on Dividends 587
How Borrowing Affects Risk and Return 529
Stock Dividends, Stock Splits, and Reverse
Debt and the Cost of Equity 530
Splits 587
16.2 Capital Structure and Corporate Taxes 533 Dividend Reinvestment Plans and Share Purchase
Debt and Taxes at River Cruises 533 Plans 588
How Interest Tax Shields Contribute to the Value
18.2 Share Repurchase 588
of Shareholders’ Equity 535
Why Repurchases are Like Dividends 589
Corporate Taxes and the Weighted-Average Cost
Repurchases and Share Valuation 590
of Capital 535
The Implications of Corporate Taxes for Capital 18.3 How Do Companies Decide on How Much to
Structure 536 Pay Out? 591
The Role of Share Repurchase Decisions 592
16.3 Costs of Financial Distress 537
The Information Content of Dividends and
Bankruptcy Costs 538
Repurchases 592
Evidence on Bankruptcy Costs 539
Direct versus Indirect Costs of Bankruptcy 540 18.4 Why Payout Policy Should Not Matter 594
Financial Distress without Bankruptcy 540 Payout Policy is Irrelevant in Efficient Financial
Costs of Distress Vary with Type of Asset 542 Markets 595
The Assumptions Behind Dividend-Irrelevance 597
16.4 Explaining Financing Choices 544
The Trade-Off Theory 544 18.5 Why Dividends May Increase Firm Value 597
A Pecking-Order Theory 544 Market Imperfections 597
The Two Faces of Financial Slack 545
18.6 Why Dividends May Reduce Firm Value 598
16.5 Bankruptcy Procedures 548 Why Pay Any Dividends at All? 599
The Choice Between Liquidation and Dividends versus Capital Gains 599
Reorganization 551 Dividend Clientele Effects 600
16.6 Summary 552 18.7 Summary 600
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Table of Contents xi

PART SIX PART SEVEN

FINANCIAL PLANNING 608 SHORT-TERM FINANCIAL
DECISIONS 673
CHAPTER 19
Long-Term Financial Planning 608 CHAPTER 21
Cash and Inventory Management 673
19.1 What is Financial Planning? 609
Financial Planning Focuses on the Big Picture 610 21.1 Cash Collection, Disbursement, and Float 675
Why Build Financial Plans? 610 Float 675
19.2 Financial Planning Models 611 Valuing Float 676
Components of a Financial Planning Model 612 21.2 The Payment System and the Float 677
Percentage-of-Sales Models 613
21.3 Managing Float 680
An Improved Model 615
Speeding Up Cheque Collections 680
19.3 Tips for Planners 620 Controlling Cheque Disbursements 681
Pitfalls in Model Design 620 Electronic Funds Transfer 682
The Assumption in Percentage-of-Sales Models 620
21.4 Managing Inventories and Cash Balances 684
Forecasting Interest Expense 622
Inventory Management Models 684
The Role of Financial Planning Models 623
Just-in-Time Inventory Management 687
19.4 External Financing and Growth 623 Managing Inventories of Cash 687
19.5 Summary 627 Uncertain Cash Flows 689
Cash Management in Large Domestic and
CHAPTER 20 International Corporations 691
Short-Term Financial Planning 635 21.5 Investing Idle Cash: The Money Market 692

20.1 Links Between Long-Term and Short-Term 21.6 Summary 695

Financing 637
CHAPTER 22
20.2 Working Capital 640 Credit Management and Collection 701
The Components of Working Capital 641
Net Working Capital, Operating Cycle, and the Cash 22.1 Terms of Sale 703
Conversion Cycle 642
22.2 Credit Agreements 705
The Working Capital Trade-Off 645
22.3 Credit Analysis 706
20.3 Tracing Changes in Cash and Working
Financial Ratio Analysis 706
Capital 647
Numerical Credit Scoring 706
20.4 Cash Budgeting 649 When to Stop Looking for Clues 708
Forecast Sources of Cash 649
22.4 The Credit Decision 708
Forecast Uses of Cash 651
Credit Decisions with Repeat Orders 710
The Cash Balance 651
Evaluating a Credit Policy Switch 712
20.5 A Short-Term Financing Plan 653 Some General Principles 712
Dynamic Mattress’s Financing Plan 654
22.5 Collection Policy 713
Evaluating the Plan 655
22.6 Summary 714
20.6 Sources of Short-Term Financing 655
Bank Loans 656
PART EIGHT
Secured Loans 657
Commercial Paper 658 SPECIAL TOPICS 722
Banker’s Acceptance 660
CHAPTER 23
20.7 The Cost of Bank Loans 660
Mergers, Acquisitions, and Corporate
Simple Interest 660
Control 722
Discount Interest 661
Interest with Compensating Balances 661 23.1 Sensible Motives for Mergers 724
20.8 Summary 662 Increased Revenues 727
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xii Table of Contents

Economies of Scale 727 24.4 International Capital Budgeting 770

Economies of Vertical Integration 727 Net Present Value Analysis 770
Combining Complementary Resources 728 The Cost of Capital for Foreign Investment 771
Merging to Reduce Taxes 728 Political Risk 772
Mergers as a Use for Surplus Funds 728 Avoiding Fudge Factors 776
23.2 Dubious Reasons for Mergers 729 24.5 Summary 776
Diversification 729
The Bootstrap Game 729 CHAPTER 25
23.3 The Mechanics of a Merger 730 Options 784
The Form of Acquisition 730
Mergers, Antitrust Law, and Popular Opposition 732 25.1 Calls and Puts 785
Selling Calls and Puts 788
23.4 Evaluating Mergers 733 Payoff Diagrams are Not Profit Diagrams 789
Mergers Financed by Cash 733 Financial Alchemy with Options 790
Mergers Financed by Stock 735 Some More Option Magic 790
Some Tax Issues 736
A Warning 736 25.2 What Determines Option Values? 792
Another Warning 736 Upper and Lower Limits on Option Values 792
The Determinants of Option Value 793
23.5 The Market for Corporate Control 737 Option-Valuation Models 795
Ownership Structure and the Effectiveness of the
25.3 Spotting the Option 797
Market for Corporate Control 737
Options on Real Assets 797
23.6 Method 1: Proxy Contests 738 Options on Financial Assets 799
23.7 Method 2: Takeover Bids 739 25.4 Summary 802
Takeover Bid Tactics 740 Appendix 25A: The Black-Scholes Option Valuation
23.8 Method 3: Leveraged Buyouts 741 Model (available on Connect)
Barbarians at the Gate? 743
Recent LBO Activity 744 CHAPTER 26
23.9 Method 4: Divestitures, Spin-Offs, and Equity Risk Management 809
Carve-Outs 746
26.1 Why Hedge? 810
23.10 The Benefits and Costs of Mergers 747 The Evidence on Risk Management 812
23.11 Summary 748 26.2 Reducing Risk with Options 812
26.3 Futures Contracts 813
CHAPTER 24 The Mechanics of Futures Trading 817
International Financial Management 754 Commodity and Financial Futures 818

24.1 Foreign Exchange Markets 755 26.4 Forward Contracts 819

Spot Exchange Rates 756 26.5 Swaps 819
Forward Exchange Rates 758
26.6 Innovation in the Derivatives Market 822
24.2 Some Basic Relationships 760
26.7 Is “Derivative” a Four-Letter Word? 822
Exchange Rates and Inflation 760
Inflation and Interest Rates 763 26.8 Summary 824
Interest Rates and Exchange Rates 764 Appendix A: Present Value Tables 829
The Forward Rate and the Expected Spot Rate 766
Some Implications 767 Appendix B: Answers to Selected End-of-Chapter
Problems 837
24.3 Hedging Exchange Rate Risk 768
Transaction Risk 768 Glossary 845
Economic Risk 769 Index 850
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Preface

This book is about corporate finance. It focuses on how com- Modern financial management is not “rocket science.” It is
panies invest in real assets and how they raise the money to a set of ideas that can be made clear by words, graphs, and
pay for these investments. It also provides a broad introduction numerical examples. The ideas provide the “why” behind the
to the financial landscape, discussing, for example, the major tools that good financial managers use to make investment
players in financial markets, the role of financial institutions and financing decisions.
in the economy, and how securities are traded and valued by
investors. The book offers a framework for systematically WHY USE OUR BOOK
thinking about most of the important financial problems that
We wrote this book to make financial management clear,
both firms and individuals are likely to confront.
useful, interesting, and fun for the beginning student. We set
Financial management is important, interesting, and chal-
out to show that modern finance and good financial practice
lenging. It is important because today’s capital investment deci-
go together—even for the financial novice. The key to this is
sions may determine the businesses that the firm is in 10, 20, or
a thorough understanding of the principles and mechanics of
more years ahead. Also, a firm’s success or failure depends in
the time value of money. This material underlies almost all of
large part on its ability to find the capital that it needs.
this text, and we spend a lengthy Chapter 5 providing exten-
Finance is interesting for several reasons. Financial deci-
sive practice with this key concept.
sions often involve huge sums of money. Large investment
The second component of our approach is the extensive use
projects or acquisitions may involve billions of dollars. Also,
of numerical examples. Each chapter presents detailed numeri-
the financial community is international and fast-moving,
cal examples to help the reader become familiar and comfort-
with colourful heroes and a sprinkling of unpleasant villains.
able with the material. We have peppered the book with real-life
Finance is challenging. Financial decisions are rarely cut
illustrations of the chapters’ topics. Some of these are excerpts
and dried, and the financial markets in which companies oper-
from the financial press found in Finance in Action boxes;
ate are changing rapidly. Good managers can cope with rou-
others are built into the text as examples. By connecting con-
tine problems, but only the best managers can respond to
cepts with practice, we strive to give students a working ability
change. To handle new problems, you need more than rules of
to make financial decisions.
thumb; you need to understand why companies and financial
We have streamlined the treatment of most topics to avoid
markets behave as they do and when common practice may
getting bogged down in unnecessary detail that can over-
not be best practice. Once you have a consistent framework for
whelm a beginner. We don’t assume users will have a lot of
making financial decisions, complex problems become more
background knowledge.
manageable.
We have written the book in a relaxed and informal writing
This book provides that framework. It is not an encyclope-
style. We use mathematical notation only where necessary.
dia of finance. It focuses instead on setting out the basic prin-
Even when we present an equation, we usually write it in
ciples of financial management and applying them to the main
words before using symbols. This approach has two advan-
decisions faced by the financial manager. It explains why the
tages: it is less intimidating and it focuses attention on the
firm’s owners would like the manager to increase firm value
underlying concept rather than just the formula.
and shows how managers choose 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 WAYS TO USE OUR BOOK
and discusses why companies may prefer a particular source of There are about as many effective ways to organize a course in
finance. corporate finance as there are teachers. For this reason, we have
Some texts shy away from modern finance, sticking instead ensured that the text is modular, so that topics can be intro-
with more traditional, procedural, or institutional approaches. duced in different sequences. Nonetheless, in this edition we
These are supposed to be easier or more practical. We disagree have changed the sequencing of chapters to improve the logical
emphatically. The concepts of modern finance, properly flow of topics. For instance, the chapter on financial statement
explained, make the subject simpler, not more difficult. They analysis has been moved ahead and is now Chapter 4 (Measuring
are also more practical. The tools of financial management are Corporate Performance) as we recognize that many instructors
easier to grasp and use effectively when presented in a consis- will prefer to go directly to this topic after covering Chapter 3
tent conceptual framework. Modern finance provides that (Accounting and Finance), as a gentler transition from a typical
framework. prerequisite accounting course. Also, recognizing that firms
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xiv Preface

have the choice of making investment decisions by either in Action article on prediction markets. Coverage of financial
taking on debt in order to purchase assets or by leasing those intermediaries has expanded coverage of exchange traded
assets, the chapter on leasing has been moved forward as funds (EFTs) and hedge funds. A non-technical introduction
Chapter 17 and now follows the one on debt policy (Chapter 16). to the idea of the opportunity cost of capital provides context
We have made sure that Part Six (Financial Planning) can for the later discussion of present value.
easily follow Part One (Introduction). Similarly, we discuss Chapter 3 (Accounting and Finance) includes a discussion
working capital after the basic principles of valuation and of new Canadian accounting standards for public companies,
financing, but we recognize that many instructors prefer to which are the International Financial Reporting Standards
reverse that order. There should be no difficulty in using Part (IFRS). The discussion of profits versus cash flow includes
Seven (Short-Term Financial Decisions) out of order. When more examples of how accrual accounting impacts cash flow.
we discuss project valuation in Part Two (Value), we stress The tax rates have also been updated.
that the opportunity cost of capital depends on project risk. Chapter 4 (Measuring Corporate Performance—formerly
But we do not discuss how to measure risk or how return and titled Financial Statement Analysis) was previously Chapter 17
risk are linked until Part Three (Risk). This ordering can of the text. In response to user comments, we have moved this
easily be modified. For example, the chapters on risk and chapter to Part One to accompany the previous chapter on
return can be introduced before, after, or midway through the accounting and finance. We also have extensively rewritten
material on project valuation. the chapter with a sharper focus on how financial data can be
used to measure contributions to firm value.
CHANGES IN THE FIFTH CANADIAN Chapter 5 (The Time Value of Money) has been updated
EDITION and rearranged to improve logical flow. The chapter includes
This fifth Canadian edition of Fundamentals includes many new spreadsheet applications.
updates. We have enhanced the analytical tools used with the Chapter 6 (Valuing Bonds) has been updated. The discus-
book: more spreadsheet boxes are integrated into the chapters; sion of the risk of default has been extended to include pos-
end-of-chapter problems include exercises that ask students to sible default of European governments’ debt.
use a variety of Internet resources to solve financial problems Chapter 7 (Valuing Stocks) starts with a review of stock
and integrative mini cases. The location of some chapters in the markets and trading procedures and motivates stock valuation
book has been altered to improve the logical flow of topics. In with an example of an investor considering whether to pur-
addition, we have rewritten, rearranged, and added material to chase a particular stock, RIM. We begin this discussion with
improve readability and update coverage across chapters. The valuation by comparables and the distinction between price
following are some examples of the changes that we have made. and intrinsic value. Then the details of dividend discount
Chapter 1 (Goals and Governance of the Firm) has been model are discussed. The chapter ends with a discussion of
largely rewritten to improve readability and interest. This market efficiency.
chapter and Chapter 2 include the real-life case of Research Chapter 8 (Net Present Value and Other Investment
In Motion and its founder Mike Lazaridis, illustrating how Criteria) has been streamlined and reorganized. The chapter
financial markets help infant firms grow into healthy adults. includes a new discussion, “Modified Internal Rate of Return.”
The section on business organizations has new material on Chapter 9 (Using Discounted Cash Flow Analysis to Make
private corporations and the pros and cons of being a public Investment Decisions) has been updated and the discussion of
corporation. Examples of investment and financial decisions project cash flow has been reworked to more carefully show
of well-known companies are used to illustrate the main how each of its components can be estimated. The chapter
activities of financial managers, the role of financial mar- works through a realistic comprehensive example of capital
kets, and the goals of a corporation. Keeping in mind the budgeting analysis and includes updated information on capi-
currency of certain themes, the chapter includes new discus- tal cost allowance (CCA). An appendix showing how the CCA
sion on the global financial crisis, big government bailouts, tax shield is derived is available to the reader on Connect.
credit default swaps, and the subprime mortgage crisis. New Chapter 10 (Project Analysis). The updated chapter includes
content on the ethical issues that confront managers includes revised coverage of NPV breakeven analysis. New Finance in
a Finance in Action article on the value of ethical dealings to Action material includes an article on the uncertainty associ-
maintain reputation in the context of the recent global finan- ated with development costs in the mining industry.
cial crisis. Chapter 11 (Introduction to Risk, Return, and the Oppor-
Chapter 2 (Financial Markets and Institutions) opens with tunity Cost of Capital) starts with a historical survey of returns
the history of Research In Motion. It includes new coverage of on bonds and stocks and goes on to distinguish between the
agency problems and corporate governance and a new Finance unique risk and market risk of individual stocks.
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Preface xv

Chapter 12 (Risk, Return, and Capital Budgeting) market Chapter 21 (Cash and Inventory Management) has an
data has been updated and shows how to measure market risk updated table of payments methods in different countries
and discusses the relationship between risk and expected around the world. The discussion of just-in-time inventory
return. management has been extended to talk about the risk of not
Chapter 13 (The Weighted-Average Cost of Capital and holding inventory. The Finance in Action article deals with the
Company Valuation) market data has been updated. A new impact of environment disasters, such as Iceland’s volcano ash
discussion of the choice of the risk-free security, Treasury bill, and Japan’s earthquake and tsunami, on the access to supplies.
or long-term government bond when implementing CAPM The discussion of the various types of short-term investments
has been added. includes asset-backed commercial paper. A new Finance in
Chapter 14 (Introduction to Corporate Financing and Action article deals with the asset-backed commercial paper
Governance) has been extensively updated, and includes new crisis and how it was resolved.
discussion on the recent subprime crisis in the United States Chapter 22 (Credit Management and Collection) empha-
and its impact on credit markets and economic activity in sizes that buying goods on credit is in effect a loan from the
countries around the world, including Canada. Two new supplier. The equation for calculating the effective annual inter-
Finance in Action boxes discuss the fallout from the crisis and est rate when using trade credit has been revised to show vari-
another examines the bounce back of corporate financing ous ways to assess the impact of forgoing the cash discount.
activity in Canada, in which debt markets have played an Chapter 23 (Mergers, Acquisitions, and Corporate Control)
important role. has been fully reorganized, and now begins with an overview
Chapter 15 (Venture Capital, IPOs, and Seasoned Offer- of why mergers and other forms of reorganization may make
ings). The chapter has updated material on developments in the sense. Next are the mechanics of acquisitions and barriers to
IPO market. An appendix to the chapter discussing the financ- mergers, including antitrust law, political and public opposi-
ing of new and small enterprises has been rewritten to reflect tion, and merger evaluation. Then we progress to the market
changes in the venture capital industry and other sources of for corporate control and discuss various methods for achiev-
small business financing in Canada. ing corporate control: proxy contests, takeovers, leveraged
Chapter 16 (Debt Policy) has been updated with Canadian buyouts and then divestitures, equity spin-offs, and carve-
examples and statistics in the discussions on costs of financial outs. The chapter has many new examples and data.
distress and explaining financing choices. Chapter 24 (International Financial Management) has new
Chapter 17 (Leasing) has been moved forward and discussion on the global financial crisis including two Finance
included with the other two chapters on financing decisions, in Action articles on the effects of the crisis on Greece and on
namely debt policy and payout policy. The chapter has been other Eurozone countries. Another new Finance in Action box
updated to include two new Finance in Action boxes assessing discusses the implications of a strengthening Canadian dollar
the impact of accounting under IFRS on the retail and trans- and the possibility of it being overvalued.
portation industries. Chapter 25 (Options) has updated market and institutional
Chapter 18 (Payout Policy) has been extensively updated information. A new subsection, Payoff Diagrams Are Not
and revised to reflect its broader focus on share repurchases Profit Diagrams, provides new drawings of call and option
along with dividend policy. A new Finance in Action box dis- payoffs with the costs of the call and option subtracted from
cusses George Weston’s special dividend payout. the payoff. This shows the net payoff from the option. Also a
Chapter 19 (Long-Term Financial Planning—formerly new subsection on executive and employee stock options has
titled Financial Planning). The concept of net operating work- been added. The discussion includes option backdating issues
ing capital (5 operating current assets – operating current lia- and an example of a company that had its shareholders approve
bilities) has been added. All interest-bearing liabilities, including a stock option exchange program for its employees.
operating lines of credit, are classified as sources of financing, Chapter 26 (Risk Management) includes updated discus-
not included in the operating current liabilities. The discussion sion on different ways to manage risk. The chapter includes new
of forecasting interest expense explains the implications of cal- writeup on derivative instruments such as credit default swaps
culating the current year’s interest expense on the basis of the in the context of the global financial crisis. Two new Finance in
assumption of when the new debt is acquired. Action articles provide further context. The first examines the
Chapter 20 (Short-Term Financial Planning) has been role of Goldman Sachs in their dealings with mortgage-related
updated with new examples of short-term financing. A new instruments and with AIG, the giant insurer. The second exam-
Finance in Action has been added that deals with the impor- ines Goldman’s role in the financial crisis through some of its
tance of working capital management for coping with the speculative activities with derivative products.
financial crisis.
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xvi Preface

PEDAGOGY WALK-
18

PART 5
THROUGH Debt and
Payout CHAPTER
To provide guidance and insights Policy return on their investment. Some long-established
companies have never yet paid a cash dividend.
Sooner or later, however, most corporations do pay

throughout the text, we include a 16 Debt Policy

17 Leasing
out cash to their shareholders. They pay dividends,
or they use cash to buy back previously issued shares.
18 Payout Policy How much should a company pay out in a given

number of proven pedagogical aids: 18.1 How Dividends Are Paid

18.2 Share Repurchase
year? Should the payout come as dividends or
share repurchases? The answers to these two ques-
tions are the corporation’s payout policy.
18.3 How Do Companies This investor is obviously delighted with his extra cash, but can
Decide on How Much companies increase share value simply by increasing their We start the chapter with a discussion of how

Payout Policy
to Pay Out? dividend payout?
dividends are paid. We then show that in an ideal
18.4 Why Payout Policy Everett Collection.
world, the value of a firm would be independent
Should Not Matter
of its dividend policy. This demonstration is in the
18.5 Why Dividends May
Increase Firm Value
In this chapter we explain how companies set their same spirit as the Modigliani and Miller debt-
18.6 Why Dividends May
payout policy, and discuss the controversial ques- irrelevance proposition of Chapter 16.
Reduce Firm Value tion of how dividend policy affects value. That leads us to look at the real-world complica-
18.7 Summary Shareholders invest in the company when they tions that might favour one dividend policy over
buy newly issued shares and when the company another. These complications include transaction
reinvests earnings on the shareholders’ behalf. The costs, taxes, and the signals that investors might
shareholders do not usually demand a prompt cash read into the firm’s payout announcement.

CHAPTER OPENING LEARNING OBJECTIVES

After studying this chapter, you should be able to:

Each chapter begins with numbered LO1

LO2
Describe how dividends are paid and how companies decide on
dividend payments.
Explain how share repurchases are used to distribute cash to
LO1 18.1 HOW DIVIDENDS ARE PAID
shareholders. CASH DIVIDENDS
learning objectives (LOs) included to LO3 Explain why dividend increases and repurchases are good news
for investors and why dividend cuts are bad news. Explain why
cash dividend Payment of cash
by the firm to its shareholders.
On February 23, 2011, Maple Leaf Foods Inc. (MFI) announced a regular quarterly cash
dividend of $.04 per share, making a total payment of $.16 for the year; soon after, its board of
directors met and approved the decision. The term regular indicates that MFI expected to main-
payout policy would not affect firm value in an ideal world.

provide a quick introduction to the LO4 Show how differences in the tax treatment of dividends and capital
gains might affect dividend policy.
tain the payment in the future. If it did not want to give that kind of assurance, it could have
declared both a regular and an extra dividend. In July 2004, Microsoft did just that. The cash-rich
software giant declared a whopping US$32 billion special dividend, because it could not find any
LO5 Explain why dividends may be used by management to signal the other way to spend its sizeable cash flows. The company also declared a US$3.5 billion regular

material students will learn and should prospects of the firm. quarterly dividend and still had $20 billion cash on hand. Investors realize that extra dividends
are less likely to be repeated.1 The nearby Finance in Action box discusses the aftermath of a
special dividend declared by another cash-rich company, George Weston.
Who receives the MFI dividend? That may seem an obvious question, but because shares

understand fully before moving to the trade constantly, the firm’s records of who owns its shares can never be fully up to date. So MFI
announced that it would send a dividend cheque to all shareholders recorded in its books on
March 10, 2011. This is known as the record date.

next chapter. This is followed by a nar- 1 Companies also use the term “special dividend” for payments that are unlikely to be repeated.

rative to set the tone for what follows.

NUMBERED EXAMPLES
Numbered and titled examples are extensively integrated into the chapters to provide detailed applica-
tions and illustrations of the text material.

FINANCE IN ACTION BOXES

Almost every chapter includes at least one Finance Finance in Action
in Action box. These are excerpts, usually from the Banks and Brokerages Agree to Pay
financial press, providing real-life illustrations of Hefty Penalties
the chapter’s topics such as in the growth of lever- Canadian Imperial Bank of Commerce, National Bank of Canada and e-mailed statement. The bank is “taking additional measures to pre-
brokerages agreed to pay a total of $134 million in fines and penal- vent this from happening again.”
aged buyouts. ties to settle regulators’ claims they improperly sold asset-backed Securities regulators in Ontario, Québec, and B.C. have been
commercial paper in Canada just before the market collapsed in collaborating on a probe with the Investment Industry Regulatory
2007. Organization of Canada, OSC spokeswoman Carolyn Shaw-Rimmington
National Bank was fined $70 million by Québec regulators said in July. The investigation focused on the actions of firms selling the
and will pay $1 million for the cost of the investigation, while debt after Coventree Inc., Canada’s biggest commercial paper adminis-
CIBC, Canada’s fifth-biggest bank, was fined by Ontario regulators trator at the time, warned bank-owned dealers of ties to risky U.S. loans.
$21.7 million and will pay $300,000 in costs. The OSC also approved a settlement with HSBC Bank of Canada
Bank of Nova Scotia’s Scotia Capital unit will pay a total of under which the bank agreed to pay a fine of $5.925 million and
$29.3 million, according to an agreement approved by the Invest- $75,000 in costs. Canaccord Financial Ltd., a brokerage based in
ment Industry Regulatory Organization of Canada. Laurentian Bank Vancouver, agreed to pay IIROC a fine and costs of $3.1 million and
will pay $3.2 million. Credential Securities Inc. will pay $200,000 in fines and costs.
The banks agreed to settle for their roles in selling commercial In a July 2007 e-mail, Coventree alerted the dealers that some of
paper in late July and early August of 2007, before the market col- its debt funds had ties to U.S. subprime mortgages, according to
lapsed on concern about ties to U.S. subprime mortgages. About court filings. The market collapsed three weeks late. CIBC kept sell-
$32 billion of the debt became insolvent, leading to a court-ordered ing the paper until Aug. 3, when it became concerned over its
plan in which the short term debt was swapped for longer term notes liquidity according to the settlement

INTERNATIONAL ICON
An international icon appears where the authors discuss global issues.

ETHICS ICON
An ethics icon appears where the authors discuss ethical issues or the
implications of unethical practices.
The value of a stock
is the present value
of the dividends it
will pay over the
KEY POINTS investor’s horizon
These marginal boxes, identified with a key icon, summarize plus the present
the importance of the adjoining material, at the same time value of the expected
helping students focus on the most critical content. stock price at the
end of that horizon.
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Preface xvii

CHECK POINT QUESTIONS Check Point 3.6 Would the following activities increase or decrease the firm’s cash balances?
Numbered Check Point boxes with questions are provided in a.
b.
Inventories are increased.
The firm reduces its trade payables.
each chapter to enable students to check their understanding c.
d.
The firm issues additional common stock.
The firm buys new equipment.
as they read. Both conceptual and calculation-type questions
have been included in this edition. Answers are provided at the
end of each chapter.

KEY FORMULAS
Key mathematical formulas, identified by a number, are called out in the text. A sum-
mary of these key formulas can be found by visiting Connect.

KEY TERMS
Key terms, when introduced, appear in colour and bold in the main text and are
defined in the margin. A glossary made up of all these definitions is also available at
the back of the book and on Connect.

CALCULATOR BOXES AND

EXERCISES financial calculator
In a continued effort to help students grasp the Using Financial Calculators to Find NPV and IRR
critical concept of time value of money, many peda-
gogical tools have been added throughout the text. We saw in Chapter 5 that the formulas for the present and future To calculate project NPV, the procedure is similar. You need to
values of level annuities and one-time cash flows are built into enter the discount rate in addition to the project cash flows, and then
Financial Calculator boxes provide examples of financial calculators. However, as the example of the office block
illustrates, most investment projects entail multiple cash flows
simply press the NPV key. Here is the specific sequence of keystrokes,
assuming that the opportunity cost of capital is 7 percent:
solving a variety of problems with directions for that cannot be expected to remain level over time. Fortunately,
many calculators are equipped to handle problems involving a Hewlett-Packard Sharp Texas Instruments
sequence of uneven cash flows. In general, the procedure is quite
the three most popular financial calculators. simple. You enter the cash flows one by one into the calculator,
HP-10B
CFj
EL-738C
CFi
BA II Plus
CF
and then you press the IRR key to find the project’s internal rate 2350,000 2350,000
of return. The first cash flow you enter is interpreted as coming 16,000 CFj 16,000 CFi 2nd {CLR WORK}

immediately, the next cash flow is interpreted as coming at the end 16,000 CFj 16,000 CFi 2350,000 ENTER ↓
of one period, and so on. We can illustrate using the office block 466,000 CFj 466,000 CFi 16,000 ENTER ↓
as an example. To find the project IRR, you would use the following 7 I/YR 7 i 16,000 ENTER ↓
sequence of keystrokes:
466,000 ENTER ↓

{NPV} NPV NPV

Hewlett-Packard Sharp Texas Instruments
7 ENTER
HP-10B EL-738C BA II Plus
↓ CPT

EXCEL SPREADSHEETS & EXHIBITS

Excel Spreadsheet boxes are integrated into many excel spreadsheet
chapters and provide the student with detailed Calculating Risk
examples of how to use spreadsheets in applying
financial concepts. They give students a valuable A B C D

introduction to financial modelling. We show how 1

2 Month
Returns, Percent
TSX CAMECO
Formulas Used in
Column C
3 May 2010 23.48 2.84
spreadsheets can be used in time-value-of-money 4
5
June 2010
July 2010
23.71
3.96
211.81
15.64

and security valuation problems, in capital budget- 6

7
August 2010
September 2010
1.90
4.09
20.61
10.18
8 October 2010 2.71 10.31
ing, and in long- and short-term planning applica- 9
10
November 2010
December 2010
2.37
4.09
17.78
18.64
tions. Questions that apply to the spreadsheet are 11
12 Standard deviation (monthly) 3.25 9.58 5STDEV(C3:C10)
13 Standard deviation, annualized 11.25 33.19
included. These spreadsheets are also available on
5C10*SQRT(12)
14 Beta, using SLOPE 2.21 5SLOPE(C3:C10,B3:B10)
15 Correlation 0.748 5CORREL(B3:B10,C3:C10)
Connect. Selected Exhibits are set as Excel Excel and most other spreadsheet programs provide built-in functions 5 Row 15 In Chapter 11 we discussed the correlation coefficient

Spreadsheets.
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xviii Preface

END-OF-CHAPTER MATERIAL Questions and Problems

The end-of-chapter features offered to support the Practise and learn online with Connect. Questions with online
Excel templates or datasets are marked with .

concepts presented are Summary, Related Web *Answers in Appendix B

Links, Key Terms, Questions and Problems, Solu- BASIC 8. Financial Targets. Managers sometimes state a target
tions to Check Points, and Mini Cases. To help 1. Financial Planning. True or false? Explain. (LO1)
a. Financial planning should attempt to minimize risk.
growth rate for sales or earnings per share. Do you think
that either one makes sense as a corporate goal? If not,
students achieve the stated learning objectives, the b. The primary aim of financial planning is to obtain
better forecasts of future cash flows and earnings.
why do you think that managers focus on them? (LO1)

LO numbers are included in the chapter Summaries c. Financial planning is necessary because financing
and investment decisions interact and should not be
INTERMEDIATE
*9. Percentage-of-Sales Models. Here are the abbreviated
and the Questions and Problems. The Questions made independently.
d. Firms’ planning horizons rarely exceed three years.
financial statements for Planners Peanuts:

and Problems incorporate Internet questions, ques-

tions with guided steps, integrative questions,
CHALLENGE
qualitative/conceptual questions, and questions that 27. Capacity Use and External Financing. Now suppose
breach the bank’s requirement that the company’s
debt ratio not exceed 60 percent?
require the use of Excel or an equivalent spread- that the long-term assets of Growth Industries (from the
previous problem) are operating at only 75 percent of
b. Same scenario as (a), except that the interest rate on
debt is 15 percent.
sheet to solve. Questions are grouped according to capacity. What is required external financing over the
next year? (LO4)
c. Same scenario as (a), except that Yummy Food
keeps its debt ratio at 40 percent.
level of difficulty; those whose answers are pro- 28. Capacity Use and External Financing. If Growth
d. Same scenario as (a), except that cost of goods sold
is 95 percent of sales each year.
Industries from problem 26 is operating at only 75 percent
vided in Appendix B are identified by an asterisk e Same scenario as (a) except each year’s interest

on the question number.

INTERNET PROBLEMS
Many problems are provided that are meant to be solved using the wealth of material available on the
Internet.

EXCEL QUESTIONS
Excel questions are incorporated into the end-of-chapter Questions and Problems, and are identified
by the icon in the margin. These templates are available for download on Connect.

MINI CASES
Integrative mini cases end many chapters. These allow students to apply their knowledge to relatively
complex, practical situations. Several new such cases have been added for this edition.

COMPREHENSIVE TEACHING AND LEARNING PACKAGE

CONNECT™
McGraw-Hill Connect™ is a web-based assignment and assessment platform that gives students the means to better connect
with their coursework, with their instructors, and with the important concepts that they will need to know for success now and
in the future. With Connect, instructors can deliver assignments, quizzes and tests easily online. Students can practice important
skills at their own pace and on their own schedule. With Connect, students also get 24/7 online access to an eBook—an online
edition of the text—to aid them in successfully completing their work, wherever and whenever they choose.

Key Features
Simple Assignment Management With Connect, creating assignments is easier than ever, so you can spend more time teaching
and less time managing.
• Create and deliver assignments easily with new banks of homework questions and test bank material to assign online
• Streamline lesson planning, student progress reporting, and assignment grading to make classroom management more efficient
than ever
• Go paperless with the eBook and online submission and grading of student assignments
Smart Grading When it comes to studying, time is precious. Connect helps students learn more efficiently by providing feed-
back and practice material when they need it, where they need it.
• Automatically score assignments, giving students immediate feedback on their work and side-by-side comparisons with correct
answers
• Access and review each response; manually change grades or leave comments for students to review
• Reinforce classroom concepts with practice tests and instant quizzes
Instructor Library The Connect Instructor Library is your course creation hub. It provides all the critical resources you’ll need
to build your course, just how you want to teach it.
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Preface xix

Instructor’s Manual
This supplement was completed by our authors, and includes a descriptive preface containing alternative course formats and case
teaching methods, a chapter overview and outline, key terms and concepts. Complete solutions to all end-of-chapter problems
are included.

Computerized Test Bank

For the computerized test bank, Sepand Jazzi of Kwantlen Polytechnic University has adapted test questions that consist of true/
false, multiple choice, and short answer questions. Questions are identified by level of difficulty and complete answers are
provided for all questions and problems, along with reference to the relevant chapter Learning Objective(s).

Microsoft® PowerPoint® Slides

These visually stimulating slides have been fully updated, by Helen Prankie of Humber College, with colourful graphs, charts,
and lists. The slides can be edited or manipulated to fit the needs of a particular course.

Image Gallery
The complete set of figures from the text can be downloaded from the image gallery on Connect and easily embedded into
instructors’ PowerPoint slides.
• Assign eBook readings and draw from a rich collection of textbook-specific assignments
• Access instructor resources, including ready-made PowerPoint presentations and media to use in your lectures
• View assignments and resources created for past sections
• Post your own resources for students to use
eBook Connect reinvents the textbook learning experience for the modern student. Every Connect subject area is seamlessly
integrated with Connect eBooks, which are designed to keep students focused on the concepts key to their success.
• Provide students with a Connect eBook, allowing for anytime, anywhere access to the textbook
• Merge media, animation, and assessments with the text’s narrative to engage students and improve learning and retention
• Pinpoint and connect key concepts in a snap using the powerful eBook search engine
• Manage notes, highlights, and bookmarks in one place for simple, comprehensive review

SUPERIOR SERVICE
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bringing you the textbook, we have consistently raised the bar in terms of innovation and educational research. These invest-
ments in learning and the education community have helped us to understand the needs of students and educators across the
country, and allowed us to foster the growth of truly innovative, integrated learning.

INTEGRATED LEARNING
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your iLearning Sales Specialist is there to help you do it. Contact your iLearning Sales Specialist today to learn how to maximize
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COURSE MANAGEMENT
McGraw-Hill Ryerson offers a range of flexible integration solutions for Blackboard, WebCT, Desire2Learn, Moodle, and other
leading learning management platforms. Please contact your local McGraw-Hill Ryerson iLearning Sales Specialist for details.

TEGRITY
Tegrity is a service that makes class time available all the time by automatically capturing every lecture in a searchable format
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 Fourth Pass
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xx Preface

ADDITIONAL TECHNOLOGY AND LEARNING SOLUTIONS

To see the latest technology and Learning Solutions offered by McGraw-Hill Ryerson and its partners, please visit us online.
www.mcgrawhill.ca/he/solutions

ACKNOWLEDGMENTS
We take this opportunity to thank all of the individuals who helped us prepare this fifth edition. We want to express our apprecia-
tion to those instructors whose insightful comments and suggestions were invaluable to us during this revision.

Ben Amoako-Adu, Wilfrid Laurier University Andras Marosi, University of Alberta

Larry Bauer, Memorial University Diana Mok, University of Western Ontario
David Birkett, University of Guelph Martin Moy, Cape Breton University
Keith Cheung, University of Windsor Howard Nemiroff, Carleton University
Larbi Hammami, McGill University Ian Rakita, Concordia University
Shahriar Hasan, Thompson Rivers University Shahbaz Sheikh, University of Western Ontario
Hui Huang, University of Waterloo Francis Tapon, University of Guelph
Andy Lin, Vancouver Island University Lachlan Whatley, Trinity Western University
Ildebrando Lucas, Algonquin College Semih Yildrim, York University
Usman Malik, Humber College

We owe much to our colleagues at the University of New Brunswick and the Schulich School of Business, York University.
We extend much gratitude to professors Dr. Tom Beechy, Ingrid McLeod-Dick and Elizabeth Farrell, accounting experts at the
Schulich School of Business, York University, who provided tremendous assistance regarding the treatment of IFRS in this text.
Thanks go to Professors Gopalan Srinivasan, Eben Otuteye and Muhammad Rashid, University of New Brunswick, for useful
suggestions, and also to the Faculty of Business Administration, University of New Brunswick, for some research support on this
project.
We would like to express our appreciation to Navid Kheradmand and Drew Cameron, University of New Brunswick, for adept
research and computational assistance and to Danielle LeBlanc, University of New Brunswick for calculator work on some end-
of-chapter problem solutions. Thanks to Andy Thi, David Jiang and Becky Zhou, Schulich undergraduate students, who did
editing and calculator work. Thanks to David Birkett, University of Guelph, for the technical review of the text. In addition, we
would like to thank our supplement authors William Lim, Helen Prankie and Sepand Jazzi. Their efforts will help students and
instructors alike.
We are also grateful to the talented staff at McGraw-Hill Ryerson, especially Kimberley Veevers, Sponsoring Editor; Daphne
Scriabin, Developmental Editor; and Graeme Powell, Supervising Editor. We want to thank copy editor Rodney Rawlings for his
energetic attention to the details.
Finally, we cannot overstate our indebtedness to our spouses, Bruce Rhodes and Koumari Mitra, and to David Rhodes, Elizabeth’s
son, and Anusha Mitra, Devashis’ daughter. They supported us and forgave us when we were very absorbed in the project.

bre0089X_fm_i-xx.indd xx 3/8/12 2:01 PM

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1
PART 1

Introduction CHAPTER

1 Goals and Governance

of the Firm

1.1 Investment and Financing

Decisions
1.2 What Is a Corporation?
1.3 Other Forms of Business
Organization
1.4 Who Is the Financial
Goals and
Manager?
1.5 Goals of the Corporation
1.6 Careers in Finance
Governance
2
1.7 Topics Covered in This Book
1.8 Summary

Financial Markets and

of the Firm
Institutions

3 Accounting and Finance

4 Measuring Corporate
Performance

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
LO1 Give examples of the investment and financing decisions that
financial managers make.
LO2 Distinguish between real and financial assets.
LO3 Cite some of the advantages and disadvantages of organizing
a business as a corporation.
LO4 Describe the responsibilities of the CFO, the treasurer, and the
controller.
LO5 Explain why maximizing market value is the logical financial goal
of the corporation.
LO6 Explain why value maximization is usually consistent with ethical
behaviour.
LO7 Explain how corporations mitigate conflicts and encourage coop-
erative behaviour.
LO8 Give examples of career paths in finance.
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corporation’s investments. Therefore we start this

chapter with examples of recent investment and
financing decisions by major Canadian and foreign
corporations. We also review what a corporation is
and describe the special roles of a corporation’s
top financial managers, including the chief finan-
cial officer (CFO), treasurer, and controller. Later in
the chapter we will review several possible career
paths in finance.
A meeting of the corporation’s directors. Next we turn to the financial goals of the corpo-
© Susan Moore. ration. Should it maximize value, or is surviving and
avoiding bankruptcy enough? Should it strive to
be a good corporate citizen? If the firm maximizes
Corporate finance boils down to the investment value for its stockholders, can it also be a good
and financing decisions made by corporations. corporate citizen? We also consider the conflicts of
Financial managers in corporations work with other interest that arise in large corporations, and review
managers to identify investment opportunities, to the mechanisms that align the interests of the firm’s
analyze and value the opportunities, and to decide managers with the interests of stockholders. Finally,
whether and how much to invest. Financial man- we look ahead to the rest of this book and back to
agers also have to raise the money to finance the some entertaining snippets of financial history.

LO1, 2 1.1 INVESTMENT AND FINANCING DECISIONS

Mike Lazaridis is best known today as one of the founders of Research In Motion (RIM), the
rapidly growing Canadian technology company known for its BlackBerry brand of handheld
smart phones. But just over 25 years ago, Lazaridis had dropped out from University of Waterloo
to operate Research In Motion with his childhood friend and business partner, Doug Fregin, in
their small office in downtown Waterloo. In the early years, the duo secured minor contracts
from large corporations such as General Motors, Kodak, and Ericsson that helped legitimize the
business. For General Motors, the company created networked display terminals that could dis-
play messages to the assembly line on big LED screens. Kodak accepted RIM’s bid to develop
the first “DigiSync Film Barcode Reader,” which revolutionized the way movies were edited in
Hollywood. RIM even won an Oscar in technical achievement for the “DigiSync” innovation.
Ericsson hired Lazaridis and Fregin to develop software for one of its new projects that would
later be known as the “Viking Express.” The software that RIM developed would prove to be the
critical missing piece to the commercial wireless e-mail puzzle. Lazaridis and Fregin had expe-
rienced their first taste of the wireless e-mail dream that would come to define the entire com-
pany some years later.
Eight years in, the company was surviving, but it was still far from being the Research In
Motion we know today. It had added 14 employees and was operating four different business
lines providing yearly revenue of around $500,000. With a strong engineering and computer
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or contact us at [email protected]
Chapter One Goals and Governance of the Firm 3

networking foundation in place, Lazaridis brought in Jim Balsillie in 1992 as co-CEO to navigate
the company with sound business practices. With Balsillie came his personal investment of
$250,000. From that point on, through a series of personal and business connections, the com-
pany was able to secure major technological research and development funding from myriad
sources, including loan and assistance programs from federal and provincial governments and
private organizations. This period also saw RIM’s initial public offering (IPO); it was the first
time the firm allowed the general public to buy shares. The new shareholders became part own-
ers of the company in proportion to the number of shares they purchased, and the company used
the funds raised for its investment outlays. RIM was able to focus on its core business.
Following years of successes and failures developing software and less-popular mobile
handhelds, Research In Motion eventually found its way in 1997. The RIM Inter@ctive Pager
950 Wireless Handheld would come to be known as the company’s first BlackBerry. The 950
was a compact device that supported a 31-key PC-style keyboard and a 1,000-entry address
book. Its key feature, however, was the ease and reliability of its portable e-mail functionality.
The response time for receiving an e-mail was an amazing 20 seconds. The device would alert
the user that an e-mail had been received without his or her having to click the “get mail” but-
ton other devices required. RIM was tasked by IBM to outfit its North American field workers
with the devices. Other large companies such as Bellsouth signed on to buy hundreds of thou-
sands of the product. Needless to say, this was RIM’s first real taste of major commercial
success.
In the 12 years since the first BlackBerry, Research In Motion has become one of Canada’s
biggest corporate success stories in recent history. According to The Globe and Mail, RIM is
currently the fourth-most-profitable company in Canada, behind only three of the largest banks
in the country. With annual sales of $15 billion, and a stock market value of over $30 billion, the
company employs almost 14,000 full-time workers. There are currently 10 different BlackBerry
models available, all of which have come a long way since the RIM 950. The newest BlackBerrys
are equipped with wireless and 3G network Internet, e-mail and text messaging, a phone, GPS,
a camera, an MP3 player, and countless other features.
In retrospect, Research In Motion’s success was hardly a sure thing. Mike Lazaridis, Doug
Fregin, and Jim Balsillie’s ideas were inspired, but their implementation was complex and dif-
ficult. It took time and considerable effort to build a customer base. Beyond the challenges posed
by its product innovation, the firm also needed to be good at finance. It had the good fortune to
get a long head start from potential competitors, but a series of bad financial decisions would
have sunk the company.
Research In Motion had to make good investment decisions. In the beginning, these decisions
were constrained. Contracts had to be carefully vetted for their chances of working out favour-
ably. Given the company’s scarce resources, every new contract it decided to undertake might
have led to the demise of the entire firm if it had failed. As the company grew, RIM’s investment
decisions became more complex. Should it incorporate a phone into the device? When should it
expand into Europe and Asia? How many unique devices should it develop? Which companies
should it acquire as it expanded its range of services and devices?
Research In Motion also had to make good financing decisions. For example, how should it
raise the money it needed for investment? In the beginning, these choices were also constrained.
Available sources of financing were limited to family money, and bank loans. As the company
grew, its range of choices expanded. Every new software contract the company received attracted
more and more attention from the Canadian Government who were attempting to establish
Canada as a worldwide technology leader in the 1990s. According to Innovation Strategy
Canada, federal and provincial governments lent or simply gave the company close to $50 mil-
lion during its “make-or-break” period in the mid and late 1990s. Jim Balsillie had some major
decisions to make when deciding how the company would finance its operations.
The initial public offering was one of those trying times. For example, how many shares
should the company try to sell? At what price? As the company grew, it periodically raised more
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4 Part One Introduction

TABLE 1.1 Examples of recent investment and financing decisions by major corporations. Unless otherwise stated, revenues,
investment costs, and financing proceeds are in Canadian dollars.

Company (2009 revenues in Recent Investment (Capital Budgeting)

$ millions) Decision Recent Financing Decision
Nokia ($59,972)—Finnish, world’s In 2007, agreed to buy Navteq Corp. for Will finance half the acquisition with its
leading mobile phone supplier $8.1 billion to gain digital maps of 69 own cash, and use borrowed money for
countries. the rest.
Royal Bank of Canada (38,143)— Acquired the fund manager Phillips Hagar Offered Phillips Hagarand North
Canada’s largest bank and North for $1.4 billion in May 2008. shareholders 27 million common shares
for the company.
EnCana Corporation ($11,335)— Purchased Deep Bossier natural gas assets Completed a public offering in the
Canadian oil and gas producer and land interests in East Texas for US$2.55 United States of senior unsecured notes
billion in 2007. in the aggregate principal amount of
US$500 million in May 2009.
Research In Motion ($15,252; Spent $148 million in March 2009 to acquire In November 2009, the company
20101)—Canadian, world-leading Certicom Corp. and Torch Mobile Inc., established an $800 million common
designer, manufacturer and marketer whose technologies will be incorporated share repurchase program.
of mobile communication devices into future RIM mobile devices.
(BlackBerry)
Shaw Communications ($3,148)— In February 2009, acquired the Campbell Issued $600 million 6.5% senior notes
Canadian cable company River cable system in British Columbia for in March 2009.
$46.3 million and the Mountain Cable
system in Ontario for $300 million just
8 months later.
Diageo ($15,687)—British, world Purchased the exclusive perpetual In 2008, issued $1.5 billion 5-year and
leading beverage company distribution rights to Ketel One Vodka 1.27 billion 6-year bonds
products in June 2008 for $708 million.
Walmart ($416,337)—U.S., world’s Spent $100 million in 2010 to purchase Has set up a $15 billion share
largest retailer Vudu, an online movie service being built repurchase program in 2010.
into an increasing amount of Blu-ray players.
McCain Foods (N/A)—Canadian, Investing £10m ($20 million) to build three (No information provided, as this is a
privately owned world-leading wind turbines at the United Kingdom’s private corporation.)
frozen french fry processor largest french fry factory
TransCanada ($8,966)—Canadian Spent $3.9 billion in 2009 to extend two Issued 22 million preferred shares in
oil and gas pipeline operator oil pipelines from Alberta to the U.S. September 2009, resulting in gross
Midwest proceeds of $600 million.

funds by selling additional stock to the public, and it borrowed money from banks. At each point,
it needed to decide on the proper form and terms of financing as well as the amounts to be
raised.1
The particulars may differ, but all successful companies, such as Research In Motion, have to
make good investment and financing decisions. Also, as with RIM, those decisions range from
prosaic and obvious to difficult, complicated, and strategically crucial.
Table 1.1 lists nine corporations, of which six are Canadian. Three are foreign: Diageo’s
headquarters are in Britain, Nokia’s in Finland, and Walmart’s in the United States. We have
chosen large corporations that you may be familiar with. Earlier you learned about RIM’s

1 The following sources were helpful in writing this section: Claire Gagné, “Douglas Fregin—The Other RIM Guy,”
Canadian Business Online, December 5, 2005, www.canadianbusiness.com/after_hours/lifestyle_activities/article
.jsp?content520051205_72913_72913; Barrie McKenna, Paul Waldie, and Simon Avery, “Patently Absurd: The
Inside Story of RIM’s Wireless War,” The Globe and Mail, January 28, 2006, B4.
Other documents randomly have
different content
 CHAPTER VI

1790: AGED FIFTEEN

HE EXHIBITS AT THE ROYAL ACADEMY AND IS DESCRIBED AS A

LIGHT-HEARTED, MERRY CREATURE

As Thomas Stothard was a customer of Turner's father, and as many

artists lived about Covent Garden, the boy's interest in art must have
been early aroused. It is said that at the age of nine young Turner made
a drawing of Margate Church, shortly before he went to his first school at
New Brentford.
An old schoolfellow tells how he drew cocks and hens on the walls, and
birds and flowers and trees from the schoolroom windows; and there is a
story, which has been learnedly revised by Notes and Queries, of a
sketch which he made of a coat-of-arms from a drawing at Mr.
Tomkison's the jeweller. At the age of thirteen he is described as short
and thick-set, with grey-blue eyes and arched eyebrows, a handsome
boy, careless of dress, but sturdy and determined.
Turner's education was perfunctory; indeed, he had no real education at
all, but he acquired the rudiments at New Brentford and in Mr. Coleman's
school at Margate. We are told that he made the journey 'in a hoy, a
bluff-bowed cutter-rigged craft, with a long bowsprit and heavy main
boom.' That voyage must have been one of the events of his boyhood.
Mr. Palice, a floral drawing-master, also had the honour of instructing
him, and Mr. Thomas Malton, a perspective draughtsman. Later he learnt
something at Paul Sandby's Drawing Academy in St. Martin's Lane, but
more from Mr. Hardwick, the architect, who employed him in adding
landscape backgrounds to plans, etc., and who introduced him, it is
believed, to the schools of the Royal Academy, where we find him
enrolled as a student in 1789. But all this was fugitive and not very
important. His real lifelong teacher was Nature, and he learnt how to
express the ways of Nature by first studying the works of his
contemporaries and predecessors.
He developed slowly. 'Folly Bridge and Bacon's Tower,' which appears as
the first item in the Inventory, under the year 1787, when he was
twelve, is not an original drawing. Turner showed little or none of the
early facility of genius. For long years he leaned on and learned from
others. 'Folly Bridge' is merely a copy of a steel engraving by J. Besire of
a drawing perhaps by E. Dayes. The colouring, says Mr. Finberg, is
probably the boy's own invention. It is signed and dated W. Turner, 1787,
and hangs to-day on a wall of the new Turner Gallery at Millbank.
From an early age he made money. His father showed his drawings and
coloured prints in his shop-window, and sold them at prices ranging from
one to three shillings. The acquisition of wealth remained one of the
most persistent occupations of his life. He was 'found out,' as Monkhouse
says, almost in his childhood, was paid for colouring prints and washing
in the skies for architects—excellent practice. The knowing boy knew it.
When, in after life, somebody expressed wonder that he should have
worked for half a crown a night, he retorted that nothing could have
been better practice. Sometimes he received as much as a guinea. An
old architect told Thornbury that he paid him that sum in the shop in
Maiden Lane for putting in a background.
But the most important episode of Turner's boyhood was the meeting
with Girtin, at about twelve or thirteen years of age, in the workshop of
the famous engraver, John Raphael Smith—Thomas Girtin, who was to
have such an influence on his dawning art, and whose personality was to
be one of the happiest memories of his life.
Turner's work up till about the age of fifteen has been summed up thus:
(1) Making drawings at home to sell; (2) Colouring prints for John
Raphael Smith; (3) Washing in backgrounds for architects; (4) Sketching
with Girtin.
Even in those early days Turner was secretive. Nobody was allowed to
see him draw, and he was as determined as he was secretive. Thornbury
tells the following story:—

'Turner was busy one morning in the bedroom at Maiden Lane,

working at some drawings for one of Britton's patrons—I think for
the Earl of Essex. Suddenly the door opens and Britton enters,
nominally to inquire how the drawings progressed, really to spy out
 all he could of Turner's professional secrets. In an instant Turner
covered up his drawings, and ran to stop the crafty intruder's
entrance.
'"I've come to see the drawings for the Earl."
'"You shan't see 'em," said Turner.
'"Is that the answer I am to take back to his lord-ship?"
'"Yes; and mind the next time you come through the shop, and not
up the back way. I allow no one to come here "; and so shutting the
door on sly Britton, Turner returned to growl at him over his work.'

The Inventory shows that Turner was hard at work at this early age. In
Sketch-Book No. II., dated 1789, twenty-five leaves are drawn on; No.
III. contains five drawings, and includes his 'First View of Oxford,' signed
and dated 1789. In Sketch-Book No. IV. there is a pencil outline of
'Wanstead New Church,' against the belfry of which he has written the
word 'Ionic.' As I have said, these Sketch-Books might also be called
general-utility books. Thus, in Sketch-Book No. V., containing drawings
probably made in the Royal Academy Schools, on the back of a black-
and-white chalk of the 'Belvedere Apollo' are these notes, showing that
his busy brain was already beginning to consider etching, and that he
was already indifferent to spelling:—
1 Get an Etching Ground, 26.
2 Heat the Back of P.
3 Rub it over with the Ball.
4 Dab it over with the Dabber of
'Well Hot. {
5 Smoke it over with Wax Tapur
6 Put some ... at back of Palte (? Plate)
7 Re ... of Wax.
Turpentine Varnish and Lamp black.'
About this time Turner began to study oil painting, receiving instruction
from no less a person than Sir Joshua Reynolds. Little did Sir Joshua
think, when he laid down the brush in 1789, that among the young men
in his studio, and perhaps working on his pictures under his
superintendence, was a youth whose name was to become as famous as
the name of Reynolds.
We can tell exactly what degree of accomplishment Turner had reached
at the age of fifteen, as the first drawing he sent to the Royal Academy,
the year being 1790, the locality Somerset House, a view of 'The
Archbishop's Palace, Lambeth,' is in a state of perfect preservation in the
collection of Mr. W. G. Rawlinson. He does not yet show any originality. It
is one of the tinted architectural drawings of the period, but the work is
conscientious, the drawing firm, and the reflected lights on the houses
well rendered. Here, too, are the Turner figures, taller than life, a little
grotesque, but accurate as regards the costumes.
He must have been a merry, attractive boy when in congenial company:
he did not lack friends. There was Mr. Narraway, whom he visited at
Bristol, and the house of Mr. W. H. Wells, the artist, was open to him,
where he was a constant and welcome inmate. Mrs. Wheeler has
recorded the following charming reminiscences of Turner at this period:—

'In early life my father's house was his second home, a haven of rest
from many domestic trials too sacred to touch upon. Turner loved
my father with a son's affection; and to me he was as an elder
brother. Many are the times I have gone out sketching with him. I
remember his scrambling up a tree to obtain a better view, and then
he made a coloured sketch, I handing up his colours as he wanted
them.... Oh! what a different man would Turner have been if all the
good and kindly feelings of his great mind had been called into
action; but they lay dormant, and were known to so very few. He
was by nature suspicious, and no tender hand had wiped away early
prejudices, the inevitable consequence of a defective education. Of
all the light-hearted merry creatures I ever knew, Turner was the
most so; and the laughter and fun that abounded when he was an
inmate of our cottage was inconceivable, particularly with the
juvenile members of the family.'

That is a happy glimpse of Turner the boy, and with that I leave his
boyhood. He has just had a drawing exhibited at the Royal Academy; he
is advancing towards proficiency in water-colour, his first and his last
love; but not yet has he reached the 'golden simplicity' that Girtin
realised, nor the 'silver sweetness' of Cozens.

CHAPTER VII

1795: AGED TWENTY

THE DRAWINGS OF 'THE INGENIUS MR. TURNER' ARE STATED

BY A NEWSPAPER OF THE DAY TO BE 'TINCTURED WITH TRUTH
AND FIDELITY'

Five years have passed. Turner is now twenty. We will glance back and
see how he has fared. At about seventeen he attracted the attention of
Dr. Thomas Monro of Bushey, and Adelphi Terrace, physician of Bridewell
and Bethlehem Hospitals, a well-known lover of art, and patron of
certain clever young men who were to raise the coloured topographical
drawing into the well-loved art of British water-colour painting. 'Good Dr.
Monro!' The phrase has become historical. Turner was grateful to Dr.
Monro all his life, although there is no evidence of any great intimacy
between them. Years later he said to David Roberts: 'Girtin and I have
often walked to Bushey and back to make drawings for good Dr. Monro
at half a crown apiece and a supper.' Turner's affection and admiration
for Girtin, that brilliant youth who died young, lasted all his life. 'Had Tom
Girtin lived I should have starved,' he is reported to have said long
afterwards; and of one of Girtin's drawings he remarked, 'I never in my
whole life could make a drawing like that. I would many a time have
given one of my little fingers to make such a one.' When quite an old
man he would mutter to himself about Tom's 'golden drawings.'
Thornbury says that he praised Girtin's 'White House' with rapture.
 Plate VI. Derwentwater, With the Falls of Lodore. Water colour (about 1797) Tate
Gallery

At Dr. Monro's house Turner, Girtin, Varley, and other young artists were
set to copy drawings by Rembrandt, Canaletto, Gainsborough, and other
masters; also the drawings of John Cozens, Turner's senior by twenty-
three years, who had lately returned from Italy and Switzerland. Cozens,
that poet with the brush, had a great influence upon him, but Turner's
drawings of this period have none of the repose, quiet beauty, and
spacious feeling of Cozens'. Perhaps the 'Pent House, Dover,' draws
nearest to the poetry of Cozens. Simple in treatment and colour, it shows
more imagination than the well-known 'Tintern Abbey' at the Victoria and
Albert Museum.
The 'Bristol and Malmesbury' Sketch-Book, dated 1791, has twenty-three
leaves, all drawn on; the 'Bristol' Sketch-Book of the same year has
seven; and in 1792 we find a drawing of the 'Burning of the Pantheon' in
Oxford Street, a carefully worked water-colour with a large number of
figures. On the left are firemen in their uniforms with hose and engines,
and a crowd of spectators and passers-by. A drawing of the 'Pantheon
the Morning after the Fire' was exhibited in the Academy of 1792. So, at
the age of seventeen, while intent now, as for years to come, on the
work of other painters, Turner had begun the direct study of life, of vivid
realities. In the 'Hereford and Worcester' Sketch-Book, 1792-93, there
are 'Two Sketches near Malvern.' Beneath the second, showing a
roadway with foreground trees, the following is inscribed in his own
handwriting:—'The distance last with the sky a lovely tint of Blue Lake
and Indian—more as it approaches.' He probably knew exactly what he
meant. And no doubt the following comment on the back of a water-
colour of a 'Tree and Tower' was all he needed to impress on his mind
the effect of what he had seen:—

'In the shadow the Stones the same. Some Umber and S. Green—
the broken part umber and Bister, the distance part a Blue Green
Sap and B.'

By the year 1795, when he was twenty years of age, Turner was quite a
successful young man. His drawings were hung at the Royal Academy, he
sold them readily, and he had been commissioned by the Copper Plate
Magazine to make a series of water-colours for engraving at two guineas
apiece. In one of the volumes of that publication he is alluded to as 'The
ingenius Mr. Turner.' Moreover, the public press had begun to notice the
work of 'the ingenius Mr. Turner.' Here is a complimentary contemporary
criticism:—

'388. "Christchurch Gate, Canterbury." W. Turner. This deserving

picture, with Nos. 333 and 336, are amongst the best in the present
exhibition. They are the productions of a very young artist, and give
strong indications of first-rate ability; the character of Gothic
architecture is most happily preserved, and its profusion of minute
parts massed with judgment and tinctured with truth and fidelity.
This young artist should beware of contemporary imitations. His
present effort evinces an eye for nature, which should scorn to look
to any other source.'
'Christchurch Gate' was one of five drawings he sent to the Academy of
1794. In 1795, 'W. Turner, Hand Court, 26 Maiden Lane, Covent Garden,'
exhibited eight drawings.
It will be seen from the above extracts from the Inventory how early
Turner became a traveller. He was a traveller almost to the end of his
life, and, whatever else he forgot, he never left his sketch-book at home.
'No day without a note of Nature' might almost have been his motto. His
sketch-books are the guides to his travels, and when I turn the pages
and follow the wanderings of this unresting man of genius, there rises
before me, as a companion to the sketch-books, the map that Mr. Huish
compiled of Turner's tours through Great Britain. The lines of his tracks
cover the map, those tracks along which he walked, or coached, or rode,
and in their appointed places are marked the sixty-six castles, the
twenty-seven abbeys, and the fourteen cathedrals that he drew. Some
day, when I have leisure, I think I will make similar maps of his tours
through France, Italy and Switzerland. He would walk his twenty miles a
day with his baggage tied in a big handkerchief, his umbrella in his hand,
and often his fishing-rod. But the clearest vision of him I have is that day
in 1792, when, at the age of seventeen, he started off on his first tour in
Wales, on a pony lent him by his friend Mr. Narraway. To be seventeen,
to be conscious of great powers, all the wide world and the wide future
opening, and a good little pony as companion. Has life anything better to
offer than that?
In the 'South Wales' Sketch-Book of 1795, among the 'Order'd Drawings,'
a list of which he has inscribed on one of the pages, is 'Newport Castle—
Mr. Kershaw.' No doubt this is the 'Newport' now in the Salting Collection
at the British Museum, one of the most accomplished of his early
drawings, pleasant in colour and bold in mass.

CHAPTER VIII

1800: AGED TWENTY-FIVE

 HIS FIRST OIL PICTURES AND EXTRACTS FROM HIS SKETCH-
BOOKS

Five more years have passed. Turner has made his North of England tour
about which Ruskin wrote so eloquently—and so unconvincingly. Cosmo
Monkhouse, while reproving Ruskin for the partial untruth of his beautiful
prose, says of that 1797 journey:—

'The effect upon Turner of the fells and vales of Yorkshire and
Cumberland seems to have been much the same as that of Scotland
upon Landseer: it braced all his powers, developed manhood of art,
turned him from a toilsome student into a triumphant master.'

Turner was not yet a triumphant master. He had progressed towards

triumph in water-colour, shown in the spacious, harmonious, and
atmospheric rendering of 'Derwentwater, with the Falls of Lodore,' and
the very beautiful 'Study for a Picture of Norham Castle'—rising golden
rocks and rosy sky reflected in the rosy water, one of two early drawings
of this subject, displayed in the new Turner Gallery, and reproduced in
these pages: but oil was still beyond him. He had not mastered the
difficulties of that medium; he could do no better than the dark and
dispiriting 'Morning on the Coniston Fells, Cumberland,' and the still
darker 'Buttermere Lake,' that for years has been banished to a
provincial gallery. The young chief had advanced; he had been elected
an Associate of the Royal Academy; he had removed from dingy Hand
Court to decorous Harley Street; and he was about to make the
acquaintance of Mr. Walter Fawkes, the squire of Farnley Hall, near
Leeds, which was to mean so much to him; but he was not yet a
triumphant master. Only in his water-colours has he begun to show
glimmerings of his golden visions. In oil he is studying detail rather than
light; he is pondering over masses looming in dim airless spaces; he has
not even yet begun to see the ethereal manifestations of his maturity.
No doubt he was elected an Associate of the Royal Academy in 1799 for
the remarkable water-colours that he exhibited in that and in the
previous year, which included the powerful sunset-glowing 'Warkworth
Castle' now at South Kensington; the gloomy and magnificent 'Kirkstall
Abbey' in the Soane Museum, and the 'Norham Castle' with the golden
rocks and the rosy sky of dawn.
Norham Castle was Turner's mascot. He painted that picturesque ruin
again and again; it appears in the Liber Studiorum and in The Rivers of
England series, and 'Norham Castle' is the subject of two of the
'unfinished oils,' disembodied spirits of loveliness, that caused such a
sensation when they were exhibited at the Tate Gallery in 1906.
In later life, when Turner was travelling with Cadell, the Edinburgh
bookseller, making sketches for Provincial Antiquities, the artist suddenly
raised his hat to the ruins and made them a low bow.
'What are you up to now? ' asked Cadell.
'Oh,' was Turner's reply, 'I made a drawing of Norham Castle several
years since. It took, and from that day to this I have had as much to do
as my hands could execute.'
Perhaps the interest of this period for students are certain early oil
paintings, showing the germs, so meagre of promise, from which his
magnificent life-work arose. The small 'Moonlight, a study at Millbank,'
exhibited in 1797, is now so dark that the picture seems to be
encompassed in a perpetual fog, dominated by a round wafery, whitey-
yellow moon; the sprawling 'Morning on the Coniston Fells' of 1798; the
'Caernarvon Castle' of 1800, silhouetted against a cloudy sky, so small
and unimposing, that, remembering what Turner became, one has for it
a sentimental affection; and the dark, disappearing 'Dolbadern Castle'
that hangs in the Diploma Gallery in Burlington House. It was exhibited
in 1800; but as Turner was not elected a full Royal Academician until
1802, this can hardly be his Diploma picture. The 'Tenth Plague of
Egypt,' exhibited in 1802, has been honoured by a place on the line in
the new Turner Gallery at Millbank.
Thomas Green, of Ipswich, is known to fame—or perhaps I should say to
the present writer—for the inscription in his diary of the following brief
criticism of Turner's oil picture, exhibited in the Royal Academy of 1797,
called 'Fishermen Coming Ashore at Sunset, Previous to a Gale ':—

'June 2nd,1797.—Visited the Royal Academy Exhibition. Particularly

struck with a sea-view by Turner; fishing-vessels coming in, with a
heavy swell, in apprehension of tempest gathering in the distance,
and casting, as it advances, a night of shade, while a parting glow is
spread with fine effect upon the shore. The whole composition bold
 in design and masterly in execution. I am entirely unacquainted with
the artist; but if he proceeds as he has begun, he cannot fail to
become the first in his department.'

Dayes, an architectural draughtsman, the master of Girtin, said of

Turner:—

'The way he acquired his professional powers was by borrowing

where he could a drawing or picture to copy from, or by making a
sketch of any one in the exhibition early in the morning and finishing
it at home.'

Another contemporary remarked of Turner, 'He must be loved for his

works, for his person is not striking or his conversation brilliant '; a third
described him as 'eccentric, but kind and amusing.' Blake, who was one
of his pupils, complained of being left quite alone, and Thornbury states
that he was too reserved and tongue-tied to be able to teach what he
knew, even if he wished to disclose his hard-earned secrets. Turner
never disclosed any of his secrets. What he knew he kept.
 Plate VII. Study for a Picture of Norham Castle. Water colour (about
1799) Tate Gallery

The Inventory from 1795 to 1800 fills nearly eighty pages of minute
records of his sketching tours. On one of the leaves of the 'South Wales'
Sketch-Book, dated 1795, I find this, but, with the exception of the
words 'Walls x White Lyon Inn,' not in his own handwriting:—

'To Tenby, 20 miles. Walls x White Lyon Inn. Before you visit Tenby
view the Castles at Llanstephen and Laugharn (Larn as it is called).
Llanstephen Castle stands at the entrance of the River Towy. At
Tenby view the cliffs, caverns, rocks, islands, etc., etc.'

The 'Studies near Brighton' Sketch-Book (1796) contains a drawing of

pigs and a donkey with this note by Ruskin:—
 'Both wonderful, quite beyond telling. There is an etching of
Rembrandt's which approaches the upper study, but by no means
equals it. Examine it for a quarter of an hour through a magnifying-
glass, and you will see something of what it is.'

When Ruskin praised, he—praised.

In another Sketch-Book of this period there is a copy by Turner of
Wilson's 'Landscape with Figures'; and in 1797 we find a book full of
Wilson copies, and labelled on the back by Turner himself, 'Studies for
Pictures. Copies of Wilson.' In the 'Swans' Sketch-Book (1798) Turner
has noted on the inside cover in ink a

'Receipt for making an Efficable (?) ointment for Cut ...'

The details of the recipe are confusedly given. On the flyleaf are several
scraps of verse, probably his own. One of them runs:—
'Tell me Babbling Echo why,
Babbling Echo tell me why,
You return me sigh for sigh;
When I of slighted love complain
You delight to Mock my Pain.'
On the back of a drawing of 'Somerset House' (?) is this (I copy the
words just as he wrote them):—
Learn. Substantives
No Comparison but by
Adjectives, as, good bonne
bad, Beau, fine Positive
Plus Beau finer Comparative
le Plus Beau Superlitive of
Finer.
Masculine Le
White Blanc Positive
Whiter Plus Blanc Comparative
Whitest Le Plus Blanc Superlitive.'
Later, in the 'Dolbadern' Sketch-Book, he has copied out a list of French
pronouns and their translations. There is something pathetic in these
attempts of Turner to make up for his lack of education.
The 'Babbling Echo' poem suggests that there may be truth in the early
love-story of which some of his biographers make much. That may or
may not have soured him; it may or may not have been the reason why
he remained a bachelor. I do not think that Turner ever thought seriously
about matrimony. His art was his mistress, and to his art to his dying day
he was loyal, to the sacrifice of everything else. And he was loyal in his
way—or shall I say faithful in his way—to Hannah Danby, who entered
his service in 1800 or 1801, a girl of sixteen; who was housekeeper in
Queen Anne Street through his long life; and who, in the end, when he
had done all his great work, found him dying in hiding as Mr. Booth,
'husband' of Mrs. Booth, in the little house at Chelsea overlooking the
river.

CHAPTER IX

1802: AGED TWENTY-SEVEN

HE EXHIBITS GRANDILOQUENT 'JASON' AND A SIMPLE 'VIEW

ON CLAPHAM COMMON'

Sometimes in early life Turner, one might say almost by chance,

prefigures the golden visions of his maturity, as in 'Conway Castle,' in the
possession of the Duke of Westminster, which dates from about this
time. The foreground is awkward, and strewn with meaningless litter;
but the castle stands up magnificently against the blue sky, darkening to
orange at the horizon, and over all is a ripe golden glow. You see this
picture across the gallery, as at the Japan-British exhibition, where it was
shown. It calls: you are held by the dawning magnificence of Turner at
twenty-seven; you realise that the magician has begun to work his spell.
The sketch-books of 1801 and 1802 are numerous and varied, showing
his travels at home and abroad: the itinerary of his first tour on the
Continent; the 'Calais Pier' Sketch-Book, with such drawings as 'Group of
Figures on Pier watching Fishing-Boats at Sea,' one of the many studies
he made for his great picture of 'Calais Pier'; and the curious and
interesting 'Studies in the Louvre' Sketch-Book, in which we find this
indefatigable young man of twenty-seven not only sitting at the feet of,
but metaphorically throwing himself into the arms of, the Old Masters.
He makes copies of many pictures, such as Titian's 'Entombment,' 'Mars
and Venus' by Domenichino, Rembrandt's 'Good Samaritan,' and to some
of the copies he appends long descriptive criticisms that often elude our
efforts to find their meaning.
His comment on 'The Deluge' by Nicholas Poussin begins:—'

The colour of this picture impresses the subject more than the
incidents, which are by no means fortunate either to place, position,
or colour, as they are separate spots untoned by the ... (? dark)
colour that pervades the whole.'

And here is his confused criticism of Rubens's 'Landscape with a

Rainbow':—

'The Rainbow appears to me the most to be considered as a picture,

not but this as well as the rest of his landscapes is defective as light
and the ... (? profusion) of nature. The woman in blue strikes the
eye and prevents it straying to the confused and ill-judged lines, but
as to the figure (? figures) in Mid, which is light ... (? lit from) the
opposite side, a proof that he wanted light on that side and either
chose to commit an error than continue the light by means of the
ground or (? to) where the sky is placed. Then it is lead by the
yellow within the trees to the sky and thence to the Bow, which is
hard and horny by the use of the vivid Blue in the distance, which is
another instance of his distorting what he was ignorant of—natural
effect.'

Among the pictures Turner exhibited this year are 'Jason in Search of the
Golden Fleece,' the earliest of his dragon pictures, that sometimes seem
rather grand, but usually merely grandiloquent. It was probably inspired
by Salvator Rosa. Turner referred to 'Jason' in later years as 'an old
favourite with some,' and Ruskin thought 'Jason' showed 'high
imaginative faculty.' How Ruskin studied Turner! Listen to this from
Modern Painters—:
 'In very sunny days a keen-eyed spectator may discern, even where
the picture hangs now, something in the middle of it like the arch of
an ill-built drain. This is a coil of the dragon beginning to unroll
himself.'

'Jason' is now well shown at the new Turner Gallery, but I, for one,
infinitely prefer the bold study for this composition, hanging in an
adjoining room. Sketch-Book LXI. is called the 'Jason' Sketch-Book.
To this period of his bolder experiments in oil belong such breezy works
as 'Dutch Boats in a Gale' at Bridgewater House, and 'Fishing Boats in a
Stiff Breeze,' both done in emulation of Van de Velde. Turner said that
seeing a fine Van de Velde in a shop-window had made him a sea-
painter.
In a letter from Andrew Caldwell to Bishop Percy, dated 14th June 1802,
Turner is spoken of 'as beating Loutherbourg and every other artist all to
nothing.'
It was not difficult for Turner to beat Van de Velde and de Loutherbourg
all to nothing. We think so now, they thought so then, if Andrew Caldwell
expressed the general opinion.

'A new artist has started up—one Turner. He had before exhibited
stained drawings, but now paints landscapes in oil, beats
Loutherbourg and every other artist all to nothing. A painter of my
acquaintance and a good judge declares his painting is magic; that it
is worth every landscape painter's while to make a pilgrimage to see
and study his works. Loutherbourg, he used to think of so highly,
appears now mediocre.'

But even in those days of rivalry with the so-called classical painters,
Turner was already beginning to see for himself, and to express what his
eyes saw. The 'View on Clapham Common,' probably painted in 1802,
merely a study of sward and trees with men angling, is personal and all
himself, although Ruskin thought that 'the somewhat affected rolling and
loading of the colour in the sky is founded altogether on Morland.'
To me it is like a brief personal and sincere utterance at a political
meeting where the speakers are all trying to say the effective thing in
the effective manner. Even such a doughty critic as Meier Graefe
recognises in this simple little picture a 'sincere surrender to the object.'
At the Tate Gallery we may see Turner, painted by himself, in the year
that he took that walk on Clapham Common, a watchful, introspective
face as of a soul trying to see through the veil, the eyes estimating and
observant, the lips betokening something sensual, the other part of
Turner.

CHAPTER X

1803: AGED TWENTY-EIGHT

THE YEAR OF 'CALAIS PIER'

Of the pictures Turner sent to the Royal Academy of 1803, including a

'Holy Family' (he tried everything in turn), one work dominates the group
—the great, dark, studio-made 'Calais Pier,' which Turner, never afraid of
a long title, called 'Calais Pier with French Poissards preparing for Sea, an
English Packet arriving.' Neither Turner nor anybody else ever saw such a
scene in Nature, and one wonders what Turner thought of this ambition
of his youth years later when he painted the pearly visions of the
'Yachting' and 'Whalers' series, or such an attempt to express the
marriage of light and water as 'Sunrise with a Sea Monster.'
He painted 'Calais Pier' in his dark studio, with half his brain mumbling
instructions to the other half as to how Van de Velde and the other
brothers of the sea would have done it. He made the sketches from
Nature as we have seen; but he had not yet arrived at the degree of
knowledge enabling him to paint a picture without losing the impulse of
the sketch. But Turner had to build his foundations: he knew that. He
could never have painted 'A Ship Aground' in 1830, unless he had
painted 'Calais Pier' in 1803. We may see from the 'Calais Pier' Sketch-
Book how minutely he acquainted himself with such scenes in Nature.
On leaf 58 is the following eloquent line in his own handwriting:—' Our
landing at Calais. Nearly swampt.'
Ruskin refers to 'Calais Pier 'as' the first picture which bears the sign
manual and the sign mental of Turner's colossal power.' He also
observes, quite rightly, that nobody is frightened and there is no danger.
And a child can see that it is untrue. Turner was never much concerned
with what we call 'truth.' The effect was his aim, not the fact. The sky,
except for the peep of blue, is black, the whole picture is dark almost to
blackness, but Ruskin sees the first indication of colour, 'properly so
called,' in the fish, and tells the following story:—

'The engraver of one of his most important marine pictures told me,
not long ago, that one day Turner came into his room to examine
the progress of the plate, not having seen his own picture for
several months. It was one of his dark, early pictures, but in the
foreground was a little piece of luxury, a pearly fish wrought into
lines like those of an opal. He stood before the picture for some
moments; then laughed, and pointed joyously to the fish, "They say
that Turner can't colour!" and turned away.'

The casual wayfarer through the Turner Gallery sees only the absurdities
of 'Calais Pier,' sniggers, perhaps, at the old fisherman in the boat who is
shaking his half-filled bottle of brandy towards the woman on the pier,
the lady having kept the rest for herself. But the artist who stands before
'Calais Pier' knows what knowledge and force there is in this dark sea
picture of Turner's youth.
Such modern sea painters as Moore, Olsson, and the Frenchman,
Matisse, have, in the beauty and truth of their realism, spoilt us for the
old sea pictures. But they contained something that we have lost. Mr. W.
L. Wyllie, A.R.A., in his book on Turner, says some fine and good things
about 'Calais Pier.' After remarking that in 'Calais Pier' the light and shade
is just that of Turner's studio in Harley Street; that the inky clouds throw
black shadows just as a table or a sofa would in a room; that the pale
blue sky is not reflected anywhere, either in the tumbling water or on the
tarry sides of the fishing-boats, he continues:—

'And yet when we are back among the conventional black old
pictures, such as 'The Shipwreck,' the 'Spithead,' or even the
impossible, gloomy 'Garden of the Hesperides,' we feel that, after
all, the old Wizard was a worker of wonders, and that he in his dark
 London room, with little more than black, brown, and grey, could
move us to awe, terror, or wonder by the thousand-and-one secrets
which he had at his fingers' ends; but which we moderns in the
struggle to be realistic may perhaps have forgotten, or even, it may
be, have never tried to learn.'

'Calais Pier,' says Thornbury, was the cause 'of one of the most painful
things 'that ever happened to any of Turner's engravers. Lupton
undertook to make a mezzotint of it, but he could not satisfy the artist.'
This is not the proportion of my picture,' said Turner, 'there is some
mistake here. These are perfect dolls' boats,' and so on. After much loss
of time and innumerable corrections, it was left unfinished. Ruskin says
that Turner got tired of his own composition; doubled the height of the
sails, pushed some of the boats further apart, and some nearer together;
introduced half a dozen more; and at last brought the whole thing into
irreparable confusion—in which it was left.
We shall never know to what degree Turner's pictures have blackened.
Burnet says that when the 'Festival upon the Opening of the Vintage of
Macon' was first painted, it was full of vivid greens and yellows. This
blackening of pictures should be an anxiety to all serious painters. Ruskin
really did a great service to Turner, perhaps even greater than the
publication of Modern Painters, when he rolled up the 'unfinished' oils
and water-colours and deposited them in the cellars of the National
Gallery. Our new joy in Turner, the rush of admiration and veneration
that came when those golden visions were exhibited in 1906, could
never have been had not they been protected from the light for so many
years: then, suddenly, to reveal their splendour.

PART THREE

1804-1810

FROM 'THE SHIPWRECK' TO AN EARLY GOLDEN

VISION
 CHAPTER XI

1804: AGED TWENTY-NINE

HE STUDIES AN ECLIPSE AND PAINTS THE SUNSET

Throughout his life Turner produced, apart from the water-colours for the
engravers, which number nearly nine hundred examples, two kinds of
work—the pictures done for fame, and those for his own delight—a
'Calais Pier,' and a 'Stonehenge at Sunset': a 'Jason' and a 'Norham
Castle.' It is hard to believe that the broad and simple water-colour,
'Stonehenge at Sunset,' with the magnificent sky, was done about the
same time as the 'Calais Pier,' but it was 'Calais Pier' that made Turner
known to the public.
Henceforth he was rarely in want of commissions from influential
patrons, including the Earls of Egremont, Essex, Lonsdale and
Yarborough, Sir John Leicester, Sir John Soane and others. He did not
always sell his oil pictures; indeed, as the years went on they remained
in increasing numbers on his hands; but that was partly his own desire.
Turner was always loath to part with his 'children.' The bulk of his
fortune was made out of the engravings.
Yes, Turner was now a successful man, but he was still, as always, a
student. The Sketch-Books, as I have said, reveal him better than reams
of commentary. Take, for example, the 'Eclipse' Sketch-Book of 1804,
showing how he worked and how he strove to understand phenomena,
even if the wonders studied did not apply actually to the work at hand.
The 'Eclipse' Sketch-Book is brief. Here are the descriptions of the six
'Eclipse' drawings he made in black and white chalk:—'
Commencement of Eclipse.
More than half of sun eclipsed.
Sun nearly three-quarters eclipsed.
Sun nearly lost among clouds.
Three-quarters of sun in eclipse.
Landscape with clouds, no sun.'