Finance, Zvi Bodie and Robert C -

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Zvi Bodie and Robert C. Merton, Upper Saddle River, New Jersey: Prentice Hall, 2000. In developing Finance Zvi Bodie and Robert Merton collected input from hundreds of colleagues teaching introductory finance courses.
Finance, Zvi Bodie and Robert C. Merton, Upper Saddle River, New Jersey: Prentice Hall, 2000.

In developing Finance Zvi Bodie and Robert Merton collected input from hundreds of colleagues teaching introductory finance courses. The result is a long awaited and exciting integration of finance principles unique to introductory texts. While most texts focus primarily if not exclusively on corporate finance, the text recognizes that there are certain laws and principles in Finance that apply across all sub fields of financial theory. The result is a very exciting synthesis of financial principles.

The book is written with the rigors of the introductory finance course at the MBA level in mind. The text is designed for, (but not limited to), those wanting a more integrated finance course. Instead of focusing exclusively on corporate finance, the text develops building blocks that are required in all areas of finance. This means that instructors in future electives will not need to develop these principles from scratch. This not only eliminates much of the duplication we see in finance textbooks, it also provides students upfront with an appreciation of the integration of financial markets, corporate finance and investments.

Another outstanding feature of the book is the integration of international material. The text is written to be current anywhere in the world. Many texts have relegated international material to separate chapters at the end of the book; here the authors rely on international examples in nearly every chapter.

The authors present ideas in a very well organized and concise manner resulting in a text that is a very digestible 455 pages. The presentation is structured to provide instructors with ample opportunity to supply further examples and expound on material in lecture. The chapter material is presented very neatly from basic principles to more advanced topics. This organization allows instructors a great deal of flexibility in the level of content and rigor that they choose to deliver. The flexibility also extends to course coverage. Instructors wishing to focus more heavily on corporate finance could focus corporate chapters more heavily, while those wishing for stronger investments coverage can focus on the investments chapters.

To expand on the application of principles, the authors have provided numerous spreadsheet-modeling exercises created by Craig Holden. These exercises are contained on a CD included with the text. Starting with a blank sheet, students follow instruction in creating models that solve complex problems. The models take 30 to 60 minutes (by author estimate) and teach students to not only create the models but how also to use them in analysis. This adds an important level of instruction to the book, as spreadsheet modeling is such an important skill in finance.

The text is divided into six parts however the author’s approach is clearly integrative. The transitions from section to section are nearly transparent and the purpose of dividing the text into sections seems to be a more concession to tradition than an attempt to place material into functional silos. Throughout the text the authors re-visit and expound on material from previous sections; for example the authors discuss Net Present Value concepts in no fewer than three different sections of the text. It is obvious that the authors worked tirelessly at integrating the text of the book.

Part I (Chapters 1-3) “Finance and the financial system” begins with a fairly straightforward introduction to finance in Chapter with one major exception; the text does not stop with defining finance from the perspective of the corporate financial manager. The text highlights financial decisions of households as well as those of corporations and it is this integration that separates this text from traditional introductory texts. The author’s have seamlessly synthesized basic investment theory and market theory with more traditional introductions to corporate financial theory.

Innovation shapes financial markets and intermediaries and Chapter 2 introduces students to financial markets with a strong emphasis on the dynamic nature of these markets. The text includes a reference to Adam Smith’s “Invisible Hand” as an example of where and how financial innovation takes place in the market. The text examines financial markets from both the personal finance and corporate finance perspectives and concludes with an introduction to financial market rates and the determinants of rates of return on different assets. Chapter 2 is also the first chapter integrating international concepts into the text with an introduction to exchange rate issues and interest rate equalization.

Chapter 3 contains a review of accounting and financial analysis. The authors keep the material contemporary with sidebar discussions on Economic Value Added (EVA), Employee Stock Option Usage and Global Accounting Rules. Nonetheless the authors include a review of financial statements, financial analysis, long-term financial planning, sustainable growth, and short-term financial planning all in one chapter. Since most introductory texts cover this material in a minimum of three chapters, many will find this coverage inadequate. The authors’ intention is obviously to provide a broad financial education beyond the traditional corporate finance coverage. Traditionally students do see some of this material in an introductory financial accounting course and should be coming to this material as a review. However my experience is that often students get caught up in the details of debits and credits in accounting and sometimes fail to see the “bigger picture”. For many students this could be the last they will see of financial analysis. Given the importance of this material in future course work as well as professional life I would like to see this chapter divided into at least two chapters. One suggestion would be to expound on financial analysis in one chapter and move and expand the coverage of financial planning in another. The added coverage could be organized in such a way as to provide even greater instructor flexibility. I am also concerned that there are only a few pages of working capital management coverage in the text. Given the importance many will find this coverage very insufficient.

Part II (Chapters 4-6) “Time and Resource Allocation” begins with an adequate coverage of time value of money techniques in Chapter 4. The text covers basic future value and present value calculations using both formulas and calculators. The text provides some derivations allowing students to see from where the formulas come. The text covers compounding, annuities, perpetuities and growth perpetuities. Further illustrating the integration of the text the authors introduce stock valuation, NPV and IRR calculations in this chapter. While some may find one chapter of coverage in this area inadequate, the authors provide the material in a clean and concise format. The text provides a foundation for instructors to expound upon in lecture with examples and further discussion where deemed appropriate.

Chapter 5 “Life Cycle Financial Planning” is unique to introductory Finance texts. The chapter provides numerous personal financial applications for the techniques learned in Chapter 4.

Chapter 6 “How to analyze Investment Projects” is the authors’ primary coverage of capital budgeting. Those wed to a traditional corporate finance approach to the first finance course may find this coverage inadequate. The authors cover capital budgeting techniques (with an obvious omission of non-discounted cash-flow techniques), cash flow analysis, risk analysis and the cost of capital in one concise chapter. Unlike other chapters this chapter is lacking in contemporary issues with no current articles or sidebars. The authors also fail to make a strong integration between real asset values and financial asset values. While the material is significantly condensed the authors still provide an introduction to a number of more advanced topics and instructors wanting a more detailed coverage of capital budgeting could easily supplement the material in lecture.

Section III (Chapters 7-9) “Valuation Models” is a more than adequate coverage of financial asset valuations. Chapter 7 provides a conceptual overview of the importance of asset valuation and the impact of information on security prices. The conceptual overview takes a refreshing break from the quantitative methods of previous chapters and asks students to see the “forest through the trees.” Somewhat unique to this text is the discussion of arbitrage and the “Law of One Price.” Consistent with the authors’ commitment to integrate international financial topics throughout the text, the chapter includes a discussion of triangular arbitrage and the appendix of Chapter 7 introduces purchasing Power parity and real interest rate parity.

Chapters 8 and 9 provide an introduction to bond and stock valuation models. The bond coverage is fairly traditional while the stock valuation coverage omits discussion of multi-stage or non-constant growth models. Chapter 9 does include an introduction to dividend policy decisions. I found this to be an excellent extension of the valuation models introduced in the chapter. Most introductory texts either ignore the dividend decision or relegate it to the end of the text.

Part IV (Chapters 10-12) “Risk Management and Portfolio Theory” defines risk and how financial markets and financial instruments can be used to reduce or eliminate risk. Chapter 10 defines risk from both the perspective of the individual and the firm, how risk can be transferred, and some of the inherent problems with risk transfer (i.e. adverse selection, moral hazard etc.). Many will find the quantitative analysis inadequate but more coverage is provided in future chapters.

Chapter 11 “Hedging, Insuring and Diversifying” provides unique coverage for an introductory text. The chapter begins with an engaging introduction to the use of forward contracts, futures and options in risk management. Students are introduced to the differences between hedging and insuring and are provided examples of each. The text again continues its international integration by illustrating how unique international risks can be managed using futures and options. The stylistic approach to portfolio theory and diversification provides a nice conceptual framework but lacks rigor.

In chapter 12 the authors integrate material from previous chapters, such as life cycle investing, with modern portfolio theory in helping students structure investment portfolios. The text provides a rigorous presentation on how to find the optimal portfolio of two risky assets. Here the authors make a significant jump in the statistical rigor of the text. Some students may benefit from a statistical tutorial or review, such as that found in most introductory texts. The authors extend the analysis from a two-asset world to a many asset world and provide Excel spreadsheets that perform the analysis for students. Students can use these files to generate portfolios and efficient frontier curves for multi-asset examples.

Part V (Chapters 13-15) “Asset Pricing” extends the valuation models of previous sections to valuing stock, futures and option contracts. Chapter 13’s development of the CAPM is more than adequate. The chapter concludes with an interesting presentation on the use of the CAPM for setting prices in regulated industries. The presentation nicely integrates the cost of capital presentation from earlier chapters.

Chapter 14 expands upon the earlier discussion on the use of futures and options contracts for hedging, speculation and arbitrage. The material begins its focus on asset pricing by examining the link between spot prices and forward prices. The detailed coverage of derivative securities in an introductory text is unique and one that I believe students will find quite challenging and interesting. The integration of the finance material is outstanding as students learn how derivatives function in controlling corporate risk, controlling unique international risks and how they can be used as personal investments.

The introduction to options and option pricing in Chapter 15 is organized, like all previous chapters, to flow from basic topics to more advanced topics. This organization provides unlimited teaching flexibility allowing instructors to teach to whatever level of rigor deemed appropriate. The chapter begins with basic option payoff structures and extends to the put- call parity relation and the relation between volatility and option value. The authors continue with a binomial option-pricing example and extend to an introduction to the Black and Scholes Model. The chapter concludes with contingent claims analysis of corporate debt and equity. While the level of rigor in the more advanced topics may be excessive for some introductory courses, the basic material at the beginning of the chapter provides an outstanding primer for first time Finance students.

The final section, Section VI, (Chapters 16-17) Corporate Finance ties together some loose ends. Chapter 16 covers the firm’s capital structure decision and provides a thorough introduction to Modigliani and Miller models as well as other incentive problems influencing a firm’s capital structure decisions. The chapter concludes with a discussion of five hypothetical firm’s capital structure choices and provides a great class discussion topic and a chance for students to apply the theories in the chapter.

Chapter 17 “Finance and Corporate Strategy” examines how finance theory is used to analyzing strategic decisions such as mergers and acquisitions, spin offs and investing in real options. While the text provides interesting examples the material seems somewhat out of place. In a book that was so carefully integrated this material could easily have been integrated into the text elsewhere, perhaps within capital budgeting chapters or in the option valuation chapters. Again the material seems to have been tacked on at this point.

I have very few criticisms of the text and all are relatively minor. One not mentioned above relates to the authors usage of contemporary examples. The authors provide contemporary examples in many chapters linking current events to theory and frequently these are presented in text boxes. However this usage isn’t consistent; some chapters have multiple examples while others have none. This can lead to the illusion that some of the topics are less important or relevant in practice. Another concern is the very brief coverage of working capital management, which is obviously such an important part of day-to-day financial management. The book is also lacking in “finance ethics” examples. Given the focus on recently on ethics in the MBA this appears an obvious omission especially with so many examples available and with the obvious market disciplines in place.

Overall Bodie and Merton’s Finance is a very interesting and insightful, (if not revolutionary), integration of finance theory at the introductory level. The authors clearly succeed in creating a text and a course that will provide students with an integrated understanding of finance. One that does not sacrifice a solid theoretical foundation but instead recognizes the integration of this theory across sub-disciplines. The obvious question is, if this format is useful at the MBA level why not the undergraduate level. I believe that, while this book was designed for students at the MBA level, this book could successfully used in some undergraduate situations by omitting some more advanced topics and if an instructor was careful to make the appropriate extensions in lecture.