Corporate Financial Management

Cover......Page 1
Brief contents......Page 8
Contents......Page 10
Topics covered in the book......Page 22
Introduction to the book......Page 24
Guided tour......Page 32
Guided tour of MyFinanceLab......Page 35
Acknowledgements......Page 38
Part 1: Introduction......Page 44
  Learning outcomes......Page 45
  Case study 1.1: Xstrata plc......Page 46
  Some possible objectives......Page 48
   The assumed objective for finance......Page 50
   Profit maximisation is not the same as shareholder wealth maximisation......Page 57
  Corporate governance......Page 59
   Corporate governance regulations......Page 60
   The introduction of money......Page 65
   Investment in a money economy......Page 66
   Interaction with the financial markets......Page 67
   Treasury management......Page 68
   Strategy and value-based management......Page 69
   Primary investors......Page 70
   conflict of preferences......Page 71
   Asset transformers......Page 72
   Intermediaries' economies of scale......Page 74
   Some reasons for the growth of financial services in the UK......Page 76
   Dynamism, innovation and adaptation – four decades of change......Page 77
   The institutions......Page 79
   The markets......Page 83
  Concluding comments......Page 84
  References and further reading......Page 86
  Self-review questions......Page 89
  Questions and problems......Page 90
  Assignments......Page 91
Part 2: The investment decision......Page 92
  Learning outcomes......Page 93
  Introduction......Page 94
  Value creation and corporate investment......Page 95
   The time value of money......Page 96
   Discounted cash flow......Page 97
   Net present value: examples and definitions......Page 99
   Internal rate of return......Page 107
  Modified internal rate of return......Page 118
   Modified internal rate of return for Project K......Page 119
  Concluding comments......Page 121
  Appendix 2.1 Mathematical tools for finance......Page 122
  Mathematical tools exercises......Page 129
  References and further reading......Page 130
  Questions and problems......Page 131
  Assignments......Page 134
 Chapter 3: Project appraisal: cash flow and applications......Page 135
  Case study 3.1: Airbus's superjumbo......Page 136
  Quality of information......Page 137
  Are profit calculations useful for estimating project viability?......Page 138
   Working capital......Page 139
   Net operating cash flow......Page 141
   Incremental cash flows......Page 143
   Dealing with interest......Page 145
  Replacement cycles......Page 150
  When to introduce a new machine......Page 157
  Timing of projects......Page 158
  The make or buy decision......Page 159
  Fluctuating output......Page 160
  References and further reading......Page 162
  Self-review questions......Page 163
  Questions and problems......Page 164
  Assignments......Page 170
  Learning outcomes......Page 171
  Introduction......Page 172
  Payback......Page 173
   Discounted payback......Page 175
  Accounting rate of return......Page 176
   Drawbacks of accounting rate of return......Page 178
  Internal rate of return: reasons for continued popularity......Page 179
  The managerial 'art' of investment appraisal......Page 180
   Generation of ideas......Page 184
   Development and classification......Page 185
   Budget......Page 186
   Report and authorisation......Page 187
   Post-completion audit......Page 188
  Key points and concepts......Page 190
  References and further reading......Page 191
  Case study recommendations......Page 193
  Questions and problems......Page 194
  Assignment......Page 196
  Learning outcomes......Page 197
   Soft rationing......Page 198
   One-period capital rationing......Page 199
  Taxation and investment appraisal......Page 202
  Inflation......Page 205
   'Real' and 'money' rates of return......Page 206
   Adjusting for inflation......Page 207
   A warning......Page 210
  Key points and concepts......Page 211
  Self-review questions......Page 212
  Questions and problems......Page 213
  Assignments......Page 217
Part 3: Risk and return......Page 218
  Learning outcomes......Page 219
  What is risk?......Page 220
   Objective probabilities......Page 221
   Subjective probabilities......Page 222
  Sensitivity analysis......Page 223
   Drawbacks of sensitivity analysis......Page 227
  Scenario analysis......Page 228
   Expected return......Page 230
   Standard deviation......Page 232
   Mean-variance rule......Page 234
   Expected net present values and standard deviation......Page 235
   Independent probabilities......Page 239
  The risk of insolvency......Page 240
   Interpreting probability distributions using different discount rates......Page 243
   Projects may be viewed in isolation......Page 245
  Real options (managerial options)......Page 246
   Some simple examples of valuable real options......Page 247
   option to abandon......Page 248
   Option to expand......Page 251
   Option to defer (timing option)......Page 253
   Difficulties with real option analysis......Page 255
  Key points and concepts......Page 256
  References and further reading......Page 257
  Case study recommendations......Page 258
  Questions and problems......Page 259
  Assignments......Page 264
  Learning outcomes......Page 265
  Holding period returns......Page 266
  Expected return and standard deviation for shares......Page 268
   The expected return......Page 269
   Comparing shares......Page 270
  Combinations of investments......Page 271
   Perfect positive correlation......Page 272
   Independent investments......Page 274
   A correlation scale......Page 275
   The effects of diversification when security returns are not perfectly correlated......Page 276
  Portfolio expected return and standard deviation......Page 278
   Covariance......Page 279
   Correlation coefficient......Page 281
  Dominance and the efficient frontier......Page 282
  Indifference curves......Page 286
   Problems with indifference curve analysis......Page 288
   Perfect negative correlation......Page 289
   Zero correlation......Page 290
  Extension to a large number of securities......Page 291
  Evidence on the benefits of diversification......Page 292
   International diversification......Page 294
  The capital market line......Page 296
  Problems with portfolio theory......Page 299
  Concluding comments......Page 302
  Key points and concepts......Page 303
  References and further reading......Page 304
  Self-review questions......Page 305
  Questions and problems......Page 306
  Assignments......Page 310
  Learning outcomes......Page 311
  Introduction......Page 312
  Some fundamental ideas and problems......Page 313
   Returns......Page 315
   Some more return data......Page 316
   Should you use the bond return or the bill return for the risk-freerate, rf?......Page 320
   Risk......Page 321
   From the capital market line (CML) to the security market line (SML)......Page 326
   Beta......Page 328
   The security market line (SML)......Page 330
   Calculating beta......Page 332
   Applications of the CAPM......Page 334
   Accepted theory and controversial theory......Page 335
   Measuring beta......Page 336
   Does the CAPM work in practice?......Page 340
  Factor models......Page 345
   A one-factor model......Page 346
   A two-factor model......Page 347
  The arbitrage pricing theory......Page 348
  The three-factor model......Page 349
  Fundamental beta......Page 350
  Project appraisal and systematic risk......Page 351
  Sceptics' views – alternative perspectives on risk......Page 352
  Concluding comments......Page 355
  Key points and concepts......Page 356
  Appendix 8.1: Note on arithmetic and geometric means......Page 357
  Comments from professors who use calculated betas......Page 358
  Comments from professors who do not use betas......Page 363
  References and further reading......Page 366
  Self-review questions......Page 369
  Questions and problems......Page 370
  Assignments......Page 371
 Chapter 9: Stock markets......Page 372
  Learning outcomes......Page 373
  Stock exchanges around the world......Page 374
   Growth of stock markets......Page 375
   Multilateral trading facilities (MTFs)......Page 377
   Deregulation......Page 380
  Why do companies list their shares on more than one exchange?......Page 381
  The importance of a well-run stock exchange......Page 384
   Securities traded......Page 386
   The primary market (equities)......Page 387
   The Alternative Investment Market (AIM)......Page 390
   PLUS–quoted shares......Page 391
  Tasks for stock exchanges......Page 392
   Types of trading......Page 393
   SETS......Page 395
   Clearing and settlement......Page 397
   Quote-driven trading......Page 398
  The ownership of UK shares......Page 399
  Regulation......Page 401
   Indices......Page 403
  Concluding comments......Page 406
  Key points and concepts......Page 407
  References and further reading......Page 408
  Self-review questions......Page 409
  Assignments......Page 410
  Learning outcomes......Page 411
  Introduction......Page 412
   Ordinary shares......Page 413
   Advantages and disadvantages of share issues......Page 414
   Limited companies, plcs and listed companies......Page 415
   Advantages to the firm of preference share capital......Page 416
   Types of preference shares......Page 417
  Some unusual types of shares......Page 418
   Prospectus......Page 419
   Conditions and responsibilities imposed......Page 420
   Suitability......Page 421
   The issuing process......Page 422
   After flotation......Page 424
   Offer for sale......Page 425
   Reverse takeover......Page 426
   A case study of a flotation – Ocado......Page 427
  How does an AIM flotation differ from one on the Official List?......Page 429
  The costs of new issues......Page 430
   An example......Page 432
   What if a shareholder does not want to take up the rights?......Page 434
   Ex-rights and cum-rights......Page 435
   The price discount decision......Page 436
  Other equity issues......Page 438
   Vendor placing......Page 439
  Scrip issues......Page 440
  Equity finance for unquoted firms......Page 441
   Business angels (informal venture capitalists)......Page 442
   Private equity/venture capital......Page 445
   Exits......Page 447
   Private equity categories......Page 452
   Corporate venturing and incubators......Page 453
  Disillusionment and dissatisfaction with quotation......Page 454
  Key points and concepts......Page 455
  Appendix 10.1: Reasons for and against floating......Page 458
  References and further reading......Page 464
  Websites......Page 465
  Self-review questions......Page 466
  Questions and problems......Page 467
  Assignment......Page 468
  Learning outcomes......Page 469
  Introduction......Page 470
  Bonds......Page 471
   Debentures and loan stocks......Page 472
   Trust deeds and covenants......Page 473
  Bank borrowing......Page 474
   Factors for a firm to consider......Page 475
  Syndicated loans......Page 477
  Credit rating......Page 478
  Mezzanine finance and high-yield (junk) bonds......Page 480
  Case study 11.1: The junk bond wizard: Michael Milken......Page 483
  Convertible bonds......Page 485
   Advantages to the company of convertible bonds......Page 487
  Valuing bonds......Page 488
   Redeemable bonds......Page 489
   The two types of interest yield......Page 491
  International sources of debt finance......Page 492
   Foreign bonds......Page 493
   Eurobonds (international bonds)......Page 494
   Types of Eurobonds......Page 495
   Issuing Eurobonds......Page 497
   Eurocommercial paper and domestic commercial paper9......Page 500
  Project finance......Page 501
  Sale and leaseback......Page 502
  Securitisation......Page 505
   Islamic bonds (sukuk)......Page 507
  The term structure of interest rates......Page 508
   The expectations hypothesis......Page 509
   The liquidity-preference hypothesis......Page 510
  Key points and concepts......Page 511
  References and further reading......Page 513
  Video presentations......Page 514
  Questions and problems......Page 515
  Assignments......Page 517
  Learning outcomes......Page 518
  Introduction......Page 519
   Bank overdraft......Page 520
   Term loans......Page 522
  Trade credit......Page 523
   Factors determining the terms of trade credit......Page 525
   1 The provision of finance......Page 526
   Case study 12.1 Prestige pet products......Page 527
   Recourse and non-recourse......Page 528
   Invoice discounting......Page 529
  Hire purchase......Page 530
   Operating lease......Page 532
   Advantages of leasing......Page 533
   To buy or to lease?......Page 536
  Bills of exchange......Page 537
  Acceptance credits (bank bills or banker's acceptance)......Page 538
   The main areas of treasury and working capital management......Page 539
   Is it better to borrow long or short?......Page 541
   To 'match' or not to 'match'?......Page 543
   The currency of borrowing......Page 545
   Retained earnings as a financing option......Page 546
   Relationships with the financial community......Page 547
  Risk management......Page 549
   Insurable risk......Page 550
   Interest-rate risk......Page 551
   The working capital cycle......Page 553
   Cash-conversion cycle......Page 554
   The dynamics of working capital......Page 557
   Working capital policies......Page 558
   Overtrading......Page 559
   Baumol's cash model......Page 561
   Some considerations for cash management......Page 564
   Trade debtor (trade receivables) management......Page 566
  Investment of temporary surplus funds......Page 570
   Investment policy......Page 571
   Investment choice......Page 572
  Concluding comments......Page 573
  Key points and concepts......Page 574
  References and further reading......Page 576
  Websites......Page 577
  Self-review questions......Page 578
  Questions and problems......Page 579
  Assignments......Page 584
  Learning outcomes......Page 585
  What is meant by efficiency?......Page 586
   Most investors are too late......Page 587
   Types of efficiency......Page 588
   The value of an efficient market......Page 589
  Random walks......Page 590
   Why does the random walk occur?......Page 591
  Weak-form tests......Page 592
   A simple price chart......Page 593
   The Dow theory......Page 594
   Other strategies......Page 595
   Return reversal......Page 597
   Price (return) momentum......Page 598
  Semi-strong form tests......Page 600
   Seasonal, calendar or cyclical effects......Page 604
   Underreaction......Page 605
   Value investing......Page 607
   Bubbles......Page 609
   Comment on the semi-strong efficiency evidence......Page 611
  Strong-form tests......Page 620
  Behavioural finance......Page 622
   The three lines of defence for EMH......Page 623
   Some cognitive errors made by investors......Page 625
  Misconceptions about the efficient market hypothesis......Page 629
  Implications of the EMH for companies......Page 630
  Concluding comments......Page 631
  Key points and concepts......Page 632
  References and further reading......Page 633
  Self-review questions......Page 642
  Questions and problems......Page 643
  Assignment......Page 644
Part 5: Corporate value......Page 646
  Learning outcomes......Page 647
  Introduction......Page 648
  Case study 14.1: Compass group......Page 650
   Confusing objectives......Page 651
  Earnings-based management......Page 653
   Accounting numbers......Page 654
   Time value of money......Page 655
   Ignoring risk......Page 657
  Return on capital employed (ROCE) has failings......Page 658
   The superficial highlighting of eps and ARR......Page 659
  How a business creates value......Page 660
   The five actions for creating value......Page 662
  An overview of the application of value principles......Page 667
  Strategic business unit management......Page 669
   Strategic assessment......Page 670
   Strategic choice......Page 676
  Corporate strategy......Page 677
  Targets and motivation......Page 681
  Concluding comments......Page 682
  Key points and concepts......Page 683
  References and further reading......Page 686
  Self-review questions......Page 687
  Questions and problems......Page 688
  Assignment......Page 690
  Learning outcomes......Page 691
  Introduction......Page 692
  Using cash flow to measure value......Page 693
   Corporate value......Page 695
   Real management is not about precise numbers – it's about what lies behind the numbers......Page 696
  Shareholder value analysis......Page 697
   Using shareholder value analysis to value an entire company......Page 699
   Strategy valuation using shareholder value analysis......Page 702
   Problems with shareholder value analysis......Page 704
   1 The entity approach to EP......Page 705
   2 The equity approach to EP......Page 706
   Usefulness of economic profit......Page 707
   The use of economic profit is becoming more widespread......Page 708
   Difficulties with economic profit......Page 709
  Economic value added (EVA®)......Page 711
  Total shareholder return (TSR)......Page 713
   Thoughtful use of the TSR......Page 714
  Wealth Added Index (WAI)......Page 715
  Market Value added (MVA)......Page 716
   Points to consider when using an MVA......Page 718
  Excess return (ER)......Page 719
  Market to book ratio (MBR)......Page 721
  Concluding comments......Page 723
  Key points and concepts......Page 724
  References and further reading......Page 727
  Self-review questions......Page 728
  Questions and problems......Page 729
  Assignments......Page 731
  Learning outcomes......Page 734
  The required rate of return......Page 735
   Two sides of the same coin......Page 736
  The weighted average cost of capital (WACC)......Page 737
   Lowering the WACC and increasing shareholder returns......Page 738
   The Capital Asset Pricing Model (CAPM)......Page 743
   The Gordon growth model method for estimating the cost of equity capital......Page 744
   Traded debt......Page 745
  Calculating the weights......Page 747
   Classic error......Page 748
  Applying the WACC to projects and SBUs......Page 749
  Empirical evidence of corporate practice......Page 750
   Cost of debt......Page 752
   Some way to go yet......Page 753
  How large is the equity risk premium......Page 754
   Progress......Page 757
  Concluding comments......Page 758
  References and further reading......Page 759
  Websites......Page 761
  Questions and problems......Page 762
  Assignment......Page 764
  Learning outcomes......Page 765
  Case study 17.1: Amazon.com......Page 766
  Valuation using net asset value (NAV)......Page 767
   When asset values are particularly useful......Page 768
  Valuation using income-flow methods......Page 770
   The dividend valuation model to infinity......Page 771
   The dividend growth model......Page 772
   Non-constant growth......Page 774
   Companies that do not pay dividends......Page 775
   Forecasting dividend growth rates – g......Page 776
   Determinants of growth......Page 777
   Another approach to estimating g......Page 778
  The price-earnings ratio (PER) model......Page 779
   PERs over time......Page 780
   The crude and the sophisticated use of the PER model......Page 781
   Cyclically adjusted price/earnings ratio (CAPE)......Page 783
  Valuation using cash flow......Page 784
  Valuation using owner earnings......Page 787
  EBITDA......Page 790
  Valuing unquoted shares......Page 792
  Unusual companies......Page 794
  Managerial control and valuation......Page 795
   Valuation models and managerial control......Page 796
  Allowing for real option values......Page 798
  Key points and concepts......Page 803
  References and further reading......Page 805
  Self-review questions......Page 806
  Questions and problems......Page 807
  Assignments......Page 813
  Learning outcomes......Page 814
  Introduction......Page 815
  Case study 18.1: The balance between debt and ordinary share capital......Page 816
   Capital gearing......Page 817
   Income gearing......Page 819
  The effect of gearing......Page 823
   Business risk and financial risk......Page 824
  Does the cost of capital (WACC) decrease with higher debt levels?......Page 828
   Proposition 1......Page 830
  The capital structure decision in a world with tax......Page 833
   Financial distress......Page 836
   Some factors influencing the risk of financial distress costs......Page 840
   Agency costs......Page 841
   Pecking order......Page 842
   Market timing......Page 843
   Financial slack......Page 844
   Industry group gearing......Page 846
   Reinvestment risk......Page 847
  Concluding comments......Page 849
  Key points and concepts......Page 852
  Appendix 18.1: Asset beta......Page 853
  Appendix 18.2: Adjusted present value (APV)......Page 855
  References and further reading......Page 856
  Video presentations......Page 859
  Questions and problems......Page 860
  Assignments......Page 862
  Learning outcomes......Page 863
  Defining the problem......Page 864
   Some background......Page 865
  Miller and Modigliani's dividend irrelevancy proposition......Page 866
   What about the world in which we live?......Page 868
  Clientele effects......Page 870
  Dividends as conveyors of information......Page 872
  Resolution of uncertainty......Page 875
  Owner control (agency theory)......Page 876
  Scrip dividends......Page 877
  Share buy-backs and special dividends......Page 878
  A round-up of the arguments'......Page 882
  Concluding comments......Page 883
  Key points and concepts......Page 884
  References and further reading......Page 885
  Self-review questions......Page 887
  Questions and problems......Page 888
  Assignments......Page 891
  Learning outcomes......Page 892
  The merger decision......Page 893
   Economic and/or strategic definitions of mergers......Page 894
  Merger statistics......Page 895
  Merger motives......Page 896
   Synergy......Page 897
   Market power......Page 900
   Case study 20.1: Economies of scale in oil......Page 901
   Entry to new markets and industries......Page 903
   Risk diversification......Page 904
   Undervalued shares......Page 905
   Hubris......Page 906
   survival......Page 907
   Third party motives......Page 908
   Cash......Page 910
   Shares......Page 911
   Other types of finance......Page 915
   The regulatory bodies......Page 916
   Pre-bid......Page 917
   The bid......Page 920
   Post-bid......Page 922
   Are target firms poor performers?......Page 923
   Does society benefit from mergers?......Page 924
   Do the directors of the acquirer gain?......Page 926
   The three stages of mergers......Page 927
   Problem areas in merger management......Page 928
   Why do mergers fail to generate value for acquiring shareholders?......Page 933
  Key points and concepts......Page 939
  References and further reading......Page 941
  Case study recommendations......Page 944
  Self-review questions......Page 945
  Questions and problems......Page 946
  Assignment......Page 948
Part 6: Managing risk......Page 950
  Learning outcomes......Page 951
  A long history......Page 952
   Call option holder (call option buyers)......Page 953
   Call option writers......Page 956
   LIFFE share options......Page 957
   Using share options to reduce risk: hedging......Page 959
  Forwards......Page 962
  Futures......Page 964
   Marking to market and margins......Page 966
   Settlement......Page 969
   Equity index futures......Page 970
   Short-term interest rate futures......Page 971
  A comparison of options, futures, forwards and FRAs......Page 976
   Floors and collars......Page 978
  Swaps......Page 980
   Speculators......Page 983
  Over-the-counter (OTC) and exchange-traded derivatives......Page 984
  Concluding comments......Page 985
  Key points and concepts......Page 986
   The factors affecting option value......Page 987
  Appendix 21.2: The relationship between FRAs and swaps......Page 988
  Case study recommendations......Page 991
  Self-review questions......Page 992
  Questions and problems......Page 993
  Assignments......Page 996
  Learning outcomes......Page 997
  Case study 22.1: What a difference a few percentage point moves on the exchange rate make......Page 998
  The effects of exchange-rate changes......Page 999
  Volatility in foreign exchange......Page 1000
   Who is trading?......Page 1002
   Twenty-four hour trading......Page 1003
  Exchange rates......Page 1004
   The spot and forward exchange markets......Page 1005
   Covering in the forward market......Page 1007
  Types of foreign-exchange risk......Page 1008
   Translation risk......Page 1009
   Economic risk......Page 1010
   Netting......Page 1011
   Matching......Page 1012
   Forward market hedge......Page 1013
   Futures hedge......Page 1014
   Currency option hedge......Page 1016
  Managing translation risk......Page 1020
  Managing economic risk......Page 1022
   Purchasing power parity......Page 1023
   Interest rate parity......Page 1025
   Expectations theory......Page 1027
   The influence of a current-account deficit and capital flows......Page 1028
  Concluding comments......Page 1029
  References and further reading......Page 1030
  Case study recommendations......Page 1031
  Self-review questions......Page 1032
  Questions and problems......Page 1033
  Assignments......Page 1035
Appendices......Page 1036
 Appendix I: Future value of £1 at compound interest......Page 1037
 Appendix II: Present value of £1 at compound interest......Page 1038
 Appendix III: Present value of an annuity of £1 at compound interest......Page 1039
 Appendix IV: Future value of an annuity of £1 at compound interest......Page 1040
 Appendix V: Areas under the standardised normal distribution......Page 1041
 Appendix VI: Answers to the mathematical tools exercises in Chapter 2, Appendix 2.1......Page 1042
Glossary......Page 1043
Bibliography......Page 1075
Index......Page 1093