1. Chapter Nineteen Financial leverage and capital structure policy
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

2. Chapter Organisation
19.1 The capital structure question 19.2 The effect of financial leverage 19.3 Capital structure and the cost of equity capital 19.4 M&M propositions I and II with corporate taxes 19.5 Bankruptcy costs 19.6 Optimal capital structure 19.7 The pie again 19.8 Imputation and M&M 19.9 Observed capital structures Summary and conclusions
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PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

3. Chapter Objectives Understand the effect of financial leverage.
Understand the impact of taxes and bankruptcy on capital structure choice.
Understand the essentials of the bankruptcy process.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

4. The Capital Structure Question
Key issues
What is the relationship between capital structure and firm value?
What is the optimal capital structure?
Capital structure and the cost of capital
The optimal capital structure is chosen if WACC is minimised.
Remind students that the WACC is the appropriate discount rate for the risk of the firm’s assets. We can find the value of the firm by discounting the firm’s expected future cash flows at the discount rate – the process is the same as finding the value of anything else. Since value and discount rate move in opposite directions, firm value will be maximised when WACC is minimised. Remind students that a firm is just a portfolio of projects, some with positive NPVs and some with negative NPVs when evaluated at the WACC. The value of the firm is the sum of the NPVs of its component projects. We already know that lower discount rates increase NPVs; consequently, decreasing the WACC will increase firm value.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

5. The Effect of Financial Leverage
Financial leverage refers to the extent to which a firm relies on debt.
The more debt financing a firm uses in its capital structure, the more financial leverage it employs.
Financial leverage can dramatically alter the payoffs to shareholders in the firm.
However, financial leverage may not affect the overall cost of capital.
Remind the students that if we increase the amount of debt in a restructuring, we are implicitly decreasing the amount of outstanding shares.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

6. Example—Computing Break-even EBIT
ABC Company currently has no debt in its capital structure. The company has decided to restructure, raising $2.5 million debt at 10 per cent. ABC currently has shares on issue at a price of $10 per share. As a result of the restructure, what is the minimum level of EBIT the company needs to maintain EPS (the break-even EBIT)? Ignore taxes.
Many students feel that if a company expects to achieve the break-even EBIT, it should automatically issue debt. You should emphasise that this is a break-even point relative to EBIT and EPS. Beyond this point, EPS will be larger under the debt alternative, but with additional debt, the firm will have additional financial risk that would increase the required return on its common share. A higher required return might offset the increase in EPS, resulting in a lower firm value despite the higher EPS. The M&M models, described in upcoming sections, will offer key points to make about this relationship.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

7. Example—Computing Break-even EBIT (continued)
With no debt:
EPS = EBIT/
With $2.5 million in 10%:
EPS = (EBIT – $ )/
1 Interest expense = $2.5 million × 10% = $
2 Debt raised will refund ($2.5 million/$10) shares, leaving shares outstanding.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

8. Example—Computing Break-even EBIT (continued)
These are then equal: EPS = EBIT/500,000 = (EBIT – $250,000)/250,000 With a little algebra: EBIT = $  EPSBE = $1.00 per share
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

9. Example—Computing Break-even EBIT (continued)
EPS ($) 3
2.5 2
1.5 1
0.5
– 0.5
– 1
D/E = 1 (with debt)
D/E = 0 (no debt)
Break-even point
EBIT ($ millions, no taxes)
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

10. The Effect of Financial Leverage
The effect of financial leverage depends on the company’s EBIT.
The break-even EBIT is where a firm makes a return just sufficient to pay the interest on debt.
If EBIT is above the break-even point, leverage is beneficial.
If EBIT is below the break-even point, leverage is not beneficial.
With financial leverage, shareholders are exposed to more risk because EPS and ROE are more sensitive to changes in EBIT.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

11. Corporate Borrowing and Home-made Leverage
Despite the effects of financial leverage, it does not necessarily follow that capital structure is an important consideration.
Why? Because shareholders can adjust the amount of financial leverage by borrowing and lending on their own.
Home-made leverage is the use of personal borrowing to alter the degree of financial leverage to which an individual is exposed.
The choice of capital structure is irrelevant if the investor can duplicate the cash flows on their own.
The examples we use ignore taxes and transaction costs. If we factor in these market imperfections, then home-made leverage will not work quite as easily, but the general idea is the same.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

12. Example—Home-made Leverage and ROE
Original capital structure and home-made leverage  investor uses $500 of their own and borrows $500 to purchase 100 shares.
Proposed capital structure  investor uses $500 of their own, together with $250 in shares and $250 in bonds.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

13. Original Capital Structure and Home-made Leverage
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

14. Proposed Capital Structure
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PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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15. Capital Structure Theory
Modigliani and Miller (M&M) Theory of Capital Structure:
Proposition I—firm value
Proposition II—WACC
The value of the firm is determined by the cash flows to the firm and the risk of the assets.
Changing firm value:
Change the risk of the cash flows.
Change the cash flows.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

16. M&M Proposition I Value of firm Value of firm
The main point with case I is that it doesn’t matter how we divide our cash flows between our shareholders and bondholders, the cash flow of the firm doesn’t change. Since the cash flows don’t change, and we haven’t changed the risk of existing cash flows, the value of the firm won’t change.
Many students wonder why we are even considering a situation in which taxes do not exist. We are trying to determine what risk-return trade-off is best for the firm’s shareholders. One way to get a good understanding of what is relevant to the capital structure decision is to start in a ‘perfect’ world and then relax assumptions as we go. By relaxing one assumption at a time, we can get a better idea of the impact on the capital structure decision. This is the classic process of ‘model building’ in economics – start simple, and add complexity one step at a time.
The size of the pie does not depend on how it is sliced.
The value of the firm is independent of its capital structure.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

17. M&M Proposition II
Because of Proposition I, the WACC must be constant, with no taxes:
WACC = RA = (E/V) × RE + (D/V) × RD
where RA is the required return on the firm’s assets
Solve for RE to get M&M Proposition II:
RE = RA + (RA – RD) × (D/E)
The main point with case I is that it doesn’t matter how we divide our cash flows between our stockholders and bondholders, the cash flow of the firm doesn’t change. Since the cash flows don’t change, and we haven’t changed the risk of existing cash flows, the value of the firm won’t change.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

18. The Cost of Equity and the WACC
Cost of capital
RE = RA + (RA – RD ) x (D/E)
WACC = RA RD
As more debt is used, the return on equity increases, but the change in the proportion of debt versus equity just offsets that increase, and the WACC does not change.
Remind students that Case I is a world without taxes. That is why the term (1 – TC) is not included in the WACC equation.
Debt-equity ratio, D/E
The firm’s overall cost of capital is unaffected by its capital structure.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

19. Business and Financial Risk
By M&M Proposition II, the required rate of return on equity arises from sources of firm risk. Proposition II is:
RE = RA + [RA – RD] × [D/E]
Business risk —equity risk arising from the nature of the firm’s operating activities (measured by RA).
Financial risk —equity risk that comes from the financial policy (i.e. capital structure) of the firm (measured by [RA – RD] × [D/E]).
Point out once again that this result assumes that the debt is risk-free. The effect of leverage on financial risk will be even greater if the debt is not default free.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

20. The SML and M&M Proposition II
How do financing decisions affect firm risk in both M&M’s Proposition II and the CAPM?
Consider Proposition II: All else equal, a higher debt/equity ratio will increase the required return on equity, RE.
RE = RA + (RA – RD) × (D/E)
Intuitively, an increase in financial leverage should increase systematic risk, since changes in interest rates are a systematic risk factor and will have more impact the higher the financial leverage.
The assumption that debt is riskless is for simplicity, and to illustrate that even if debt is default risk-free, it still increases the variability of cash flows to the shareholders, and thus increases the systematic risk.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

21. The SML and M&M Proposition II (continued)
Substitute RA = Rf + (RM  Rf)βA and by replacement RE = Rf + (RM  Rf)βE
The effect of financing decisions is reflected in the equity beta, and, by the CAPM, increases the required return on equity.
βE = βA(1 + D/E)
Debt increases systematic risk (and moves the firm along the SML).
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

22. Corporate Taxes
The interest tax shield is the tax saving attained by a firm from interest expense.
Assumptions:
perpetual cash flows
no depreciation
no fixed asset or NWC spending.
For example, a firm is considering going from $0 debt to $400 debt at 10 per cent.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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23. Corporate Taxes (continued)
Tax saving = $16 = 0.40 x $40 = TC × RD × D
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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24. Corporate Taxes (continued)
What is the link between debt and firm value?
Since interest creates a tax deduction, borrowing creates a tax shield. The value added to the firm is the present value of the annual interest tax shield in perpetuity.
M&M Proposition I (with taxes):
Key result: VL = VU + TCD
Point out that the increase in cash flow in the example is exactly equal to the interest tax shield.
The assumption of perpetual debt makes the equations easier to work with, but it is useful to ask the students what would happen if we did not assume perpetual debt.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

25. M&M Proposition I with Taxes
Value of the firm (VL)
VL = VU + TC x D
= TC
TC x D
VL= VU + $160 VU VU
RU is the cost of capital for an unlevered firm = RA for a levered firm.
VU is just the PV of the expected future cash flow from assets for an unlevered firm. VU
Total debt (D)
$400
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

26. Taxes, WACC and Proposition II
Taxes and firm value: an example
EBIT = $100
TC = 30%
RU = 12.5%
Suppose debt goes from $0 to $100 at 10 per cent. What happens to equity value, E?
VU = $100 × (1 – 0.30)/0.125 = $560
VL = $560 + (0.30 × $100) = $590
 E = $490
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

27. Taxes, WACC and Proposition II
WACC and the cost of equity (M&M Proposition II with taxes):
RE = RU + (RU – RD) × (D/E) × (1 – TC)
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

28. Taxes, WACC and Proposition II
Cost of capital (%) RE RE RU RU
WACC
WACC
Lecture Tip: According to Proposition II, RE = RA + (RA – RD)(D/E). An alternative explanation is as follows: in the absence of debt, the required return on equity equals the return on the firm’s assets, RA. As we add debt, we increase the variability of cash flows available to shareholders, thereby increasing shareholder risk.
RD  (1 – TC)
RD  (1 – TC)
Debt-equity ratio, D/E
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

29. Taxes, WACC and Propositions I and II—Conclusions
The no-tax case:
Implications of proposition I:
A firm’s capital structure is irrelevant
A firm’s WACC is the same no matter what the mixture of debt and equity is used to finance the firm.
Implications of proposition II:
The cost of equity rises as the firm increases its use of debt financing
The risk of the equity depends on two things: the riskiness of the firm’s operations (business risk) and the degree of financial leverage (financial risk).
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

30. Taxes, WACC, and Propositions I and II—Conclusions
With taxes:
Implications of proposition I:
Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is 100 per cent debt.
A firm’s WACC decreases as the firm relies on debt financing.
Implications of proposition II:
Unlike proposition I, the general implications of proposition II are the same whether there are taxes or not.
Point out that the government effectively pays part of our interest expense for us; it is subsidising a portion of the interest payment.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

31. Bankruptcy Costs Borrowing money is a good news/bad news proposition:
The good news: interest payments are deductible and create a debt tax shield (TCD).
The bad news: all else equal, borrowing more money increases the probability (and therefore the expected value) of direct and indirect bankruptcy costs.
Key issue: The impact of financial distress on firm value.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

32. Direct versus Indirect Bankruptcy Costs
Direct bankruptcy costs are costs directly associated with bankruptcy such as legal and administrative expenses.
Indirect bankruptcy costs are costs associated with spending resources to avoid bankruptcy.
Financial distress:
significant problems in meeting debt obligations.
most firms that experience financial distress do recover.
Some examples of bankruptcy costs are:
Direct costs
Legal and administrative costs.
Ultimately cause bondholders to incur additional losses.
Disincentive to debt financing.
Indirect bankruptcy costs
Larger than direct costs, but more difficult to measure and estimate.
Shareholders want to avoid a formal bankruptcy filing.
Bondholders want to keep existing assets intact so they can at least receive that money.
Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business.
The firm may also lose sales, experience interrupted operations, and lose valuable employees.
Financial distress
Significant problems in meeting debt obligations.
Firms that experience financial distress do not necessarily file for bankruptcy.
There are a multitude of companies that can be used as case studies for bankruptcy costs.
Allco Finance, Babcock and Brown, ABC Learning and Octaviar are all recent examples of companies that were too highly leveraged and suffered as a result. The resulting investigation of the companies’ affairs before they failed is yet to be completed, but will provide important examples of bankruptcy costs to students.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

33. Optimal Capital Structure
The static theory of capital structure:
A firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. This is the point at which WACC is minimised and the value of the firm is maximised.
It is called the static theory because it assumes that the firm is fixed in terms of its assets and operations, and it only considers possible changes in the debt/equity ratio.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

34. The Optimal Capital Structure and the Value of the Firm
Value of the firm (VL )
VL = VU + TC  D
Present value of tax shield on debt
Financial distress costs
Maximum firm value VL*
Actual firm value VU
VU = Value of firm with no debt
Note that we are talking about ‘expected’ in a statistical sense. If the firm goes bankrupt, it will have a certain level of costs it will incur. If the firm is all equity, then the expected bankruptcy cost is 0, since the probability of bankruptcy is 0. As the firm adds debt, the probability of incurring the bankruptcy costs increases, and thus the expected bankruptcy cost increases.
Debt-equity ratio, D/E
D/E
Optimal amount of debt
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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35. The Optimal Capital Structure and the Cost of Capital
WACC
Minimum cost of capital
RD  (1 – TC)
WACC*
Debt/equity ratio (D/E)
D*/E* The optimal debt/equity ratio
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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36. The Capital Structure Question
Value of the firm ( VL )
Case II
M&M (with taxes)
VL*
PV of bankruptcy costs
Case III Static Theory
Net gain from leverage VU
Case I
M&M (no taxes)
In theory, the static model of capital structure described in this section applies to multinational firms as well as to domestic firms. The multinational firm should seek to minimise its global cost of capital by balancing the debt-related tax shields across all of the countries in which the firm does business, against global agency and bankruptcy costs. However, this assumes that worldwide capital markets are well-integrated and that foreign exchange markets are highly efficient. In such an environment, financial managers would seek the optimal global capital structure. In practice, of course, the existence of capital market segmentation, differential taxes, and regulatory frictions make the determination of the global optimum much more difficult than the theory would suggest.
Total debt (D) D*
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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37. Managerial Recommendations
Taxes
The tax benefit is only important to firms in a tax- paying position.
The higher the tax payable, the greater the incentive to borrow.
Financial distress:
The greater the risk of financial distress, the less debt will be optimal for the firm.
All other things equal, the greater the volatility in EBIT, the less a firm should borrow.
The costs of financial distress depend primarily on the firm’s assets, and how easily ownership to those assets can be transferred.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

38. The Extended Pie Model Copyright  2011 McGraw-Hill Australia Pty Ltd
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39. Corporate Borrowing and Personal Borrowing
Without tax, corporate and personal borrowing are interchangeable.
With corporate and personal tax, there is an advantage to corporate borrowing because of the interest tax shield.
With corporate and personal tax, and dividend imputation, shareholders are again indifferent between corporate and personal borrowing.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

40. Dynamic Capital Structure Theories
Pecking order theory:
Investment is financed first with internal funds, then debt, and finally with equity.
Information asymmetry cost:
Management has superior information on the prospects of the firm.
Agency costs of debt:
These occur when equity holders act in their own best interests rather than the interests of the firm.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

41. Debt-to-Equity Ratios for Selected Australian Industries, 2009
Industry
Debt/Equity %
Banks
213
Materials 88
Engineering 59
Gas 46
Gold 9
Medical 36
Media 16
Oil 69
Property
Retail Staples 49
Telecommunications
124
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PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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42. Quick Quiz What is the break-even EBIT, and how do we compute it?
How do we determine the optimal capital structure?
What is the optimal capital structure in the three cases that were discussed in this chapter?
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker

43. Summary and Conclusions
The optimal capital structure for a firm is one that maximises the value of the firm and minimises the overall cost of capital.
If taxes, financial distress costs, and any other imperfections are ignored, the firm’s capital structure is simply irrelevant.
If company taxes are considered, capital structure matters a great deal.
Bankruptcy or financial distress costs reduce the attractiveness of debt financing.
Australian firms typically do not use great amounts of debt (but pay substantial taxes), and firms in similar industries tend to have similar capital structures.
Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker