Business Finance. Theory and Practica. Eddie McLaney PEARSON

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1 Business Finance Theory and Practica Eddie McLaney PEARSON Harlow, England London New York Boston San Francisco Toronto Sydney Auckland Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town Säo Paulo Mexico City Madrid Amsterdam Munich Paris Milan

2 Guided tour of the book Preface Plan of the book Publisher's acknowledgements xii xv xvii xviii 1 Introduction 3 Objectives The role of business finance Risk and business finance The relationship between business finance and accounting The Organisation of businesses - the limited Company Corporate governance and the role of directors Long-term financing of companies Liquidation Derivatives Private equity funds 16 Summary 17 Further reading 18 Review questions 18 2 A framework for financial decision making 19 Objectives Financial decision making Business objectives Conflicts of interest: shareholders versus managers - the 'agency' problem Financing, Investment and Separation Behavioural finance Theory and practice 32 Summary 32 Further reading 33 Review questions 33 Problem 33 Appendix: Formal derivation of the Separation theorem 35 v

3 3 Financial (accounting) statements and their Interpretation 41 Objectives Introduction The financial statements Definitions and Conventions of accounting Problems with using accounting Information for decision making Creative accounting Ratio analysis Using accounting ratios to predict financial failure 65 Summary 66 Further readirtg 67 Review questions 67 Problems 68 Appendix: Jackson plc's income statement and Statement of financial position for Investment appraisal methods 79 Objectives Introduction Net present value Internal rate of return Payback period Accounting (or unadjusted) rate of return Investment appraisal methods used in practice 99 Summary 104 Further reading 106 Review questions 106 Problems Practica! aspects of Investment appraisal 111 Objectives Introduction Cash flows or accounting flows? Do cash flows really occur at year ends? Which cash flows? Taxation Inflation An example of an Investment appraisal Capital rationing 125 vi

4 5.9 Replacement decisions Routines for identifying, assessing, implementing and reviewing Investment projects Investment appraisal and Strategie planning Value-based management Real options 142 Summary 143 Further reading 145 Review questions 146 Problems Risk in Investment appraisal 153 Objectives Introduction Sensitivity analysis Use of probabilities Expected value Systematic and specific risk Utility theory Attitudes to risk and expected value Particular risks associated with making Investments overseas Some evidence on risk analysis in practice Risk - the Störy so far 174 Summary 175 Further reading 176 Review questions 177 Problems Portfolio theory and its relevance to real Investment decisions 183 Objectives The relevance of security prices The expected value/variance (or mean/variance) criterion Security Investment and risk Portfolio theory The capital asset pricing model CAPM: an example of beta estimation Assumptions of CAPM Tests of CAPM CAPM - why the doubts? Implications of modern portfolio theory and CAPM Lack of shareholder unanimity on risky Investment Using CAPM to derive discount rates for real Investments - the practica! Problems 207 vii

5 7.13 Arbitrage pricing model Diversification within the business 210 Summary 210 Further reading 212 Review questions 212 Problems 212 Appendix: Derivation of CAPM 214 Part 3 Financing decisions 8 Sources of long-term finance 219 Objectives Introduction Ordinary (equity) capital Methods of raising additional equity finance Preference shares Loan notes and debentures Convertible loan notes Warrants Term loans Asset-backed finance (securitisation) Leasing Grants from public funds Islamic finance Conclusions on long-term finance 247 Summary 248 Further reading 251 Review questions 251 Problems The secondary capital market (the stock exchange) and its efficiency 253 Objectives Introduction The London Stock Exchange Capital market efficiency Tests of capital market efficiency The efficient market paradox Conclusions on, and implications of, capital market efficiency Behavioural finance 271 Summary 273 Further reading 274 Review questions 275 Problems 275 viii

6 10 Cost of capital estimations and the discount rate 276 Objectives Introduction Cost of individual capital elements Weighted average cost of capital (WACC) The discount rate - CAPM versus the traditional approach WACC values used in practice The use of WACC in practice Further points on WACC 293 Summary 293 Further reading 295 Review questions 295 Problems Gearing, the cost of capital and shareholders' wealth 298 Objectives Introduction Is debt finance as cheap as it seems? Business risk and financial risk The traditional view The Modigliani and Miller view of gearing Other thoughts on the tax advantage of debt financing Capital/financial gearing and operating gearing Other practical issues relating to capital gearing Evidence on gearing Gearing and the cost of capital - conclusion The trade-off theory Pecking order theory Likely determinants of capital gearing MM, modern portfolio theory and CAPM Weighted average cost of capital revisited 321 Summary 322 Further reading 323 Review questions 324 Problems 324 Appendix I: Proof of the MM cost of capital proposition (pre-tax) 327 Appendix II: Proof of the MM cost of capital proposition (after tax) The dividend decision 330 Objectives Introduction Modigliani and Miller on dividends The traditional view on dividends 333 ix

7 12.4 Who is right about dividends? Otherfactors Dividends: the evidence Conclusions on dividends 344 Summary 345 Further reading 346 Review questions 346 Problems 346 Appendix: Proof of the MM dividend irrelevancy proposition Management of working capital 355 Objectives Introduction The dynamics of working capital The importance of the management of working capital Working capital and liquidity Overtrading Inventories (stock in trade) Just-in-time inventories management Trade receivables (trade debtors or accounts receivable) Cash (including overdrafts and short-term deposits) Trade payables (trade creditors) 384 Summary 386 Further reading 389 Review questions 389 Problems Corporate restructuring (including takeovers and divestments) 392 Objectives Introduction Takeovers and mergers Mergers: the practicalities Divestments 405 Summary 408 Further reading 409 Review questions 409 Problems International aspects of business finance 412 Objectives Introduction 412 x

8 15.2 Foreign exchange Problems of internationalisation International Investment appraisal Risks of internationalisation, management of those risks and portfolio theory 431 Summary 434 Further reading 436 Review questions 436 Problems Small businesses 438 Objectives Introduction Corporate objectives Organisation of small businesses Taxation of small businesses Investment decisions Risk and the discount rate Sources of finance Valuation of small businesses Gearing Dividends Working capital and small businesses 451 Summary 453 Further reading 455 Review questions 455 Problems 455 Appendix 1 Present value table 461 Appendix 2 Annuity table 462 Appendix 3 Suggested answers to review questions 463 Appendix 4 Suggested answers to selected problems 476 Glossary 501 References 507 Index 514 xi

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