HANDBOOK OF CORPORATE FINANCE A business companion to financial markets, decisions & techniques 2nd edition Glen Arnold Financial Times Prentice Hall is an imprint of Harlow, England London New York Boston San Francisco Toronto Sydney Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town Madrid Mexico City Amsterdam Munich Paris Milan
About the author Acknowledgments Author's acknowledgments What's new in the second edition xiii xiv xix xx xxi 1 What is the firm's objective? l 2 A common purpose 2 The assumed objective for finance 7 What is shareholder value? 13 Profit maximization is not the same as shareholder wealth-maximization 13 Corporate^governance 15 What happens if control over directors is weak? 26 28 Notes 29 SECTION I: INVESTING IN PROJECTS 2 State-of-the-art project appraisal techniques 33 ' 34 How do you know whether an investment generates value for shareholders? 35 State-of-the-art technique 1: net present value 40 State-of-the-art technique 2: internal rate of return 50 Choosing between NPV and IRR 58 60 Appendix 2.1 Mathematical tools for finance 61 3 Traditional appraisal techniques 71 72 What appraisal techniques do businesses use? 72 Payback 72 Accounting rate of return " 77 Internal rate of return: reasons for continued popularity 80 81
VI CONTENTS 4 Investment decision-making in companies 83 84 The managerial art of investment selection 85 More tricky issues in real-world project appraisal 91 Taxation and investment appraisal 95 The stages of investment decision-making 98 107 5 Allowing for risk in project appraisal 109 111 What is risk? Ill Adjusting for risk through the discount rate 114 Sensitivity analysis ' 114 Scenario analysis 120 Probability analysis 122 Problems with using probability analysis 128 Evidence of risk analysis in practice 128 Real options (managerial options) 129 136 Notes 136 SECTION II: SHAREHOLDER VALUE 6 Value managed vs earnings managed companies 139 140 The pervasiveness of the value approach 140 Case study: Compass Group 143 Why shareholder value? 145 Three steps to value 147 Earnings-based management's failings 147 Return on capital employed (ROCE) has failings 154 Focusing on earnings is not the same as value 155 How a business creates value 156 The five actions for creating value 159 165 Notes 166 7 Value through strategy 167 168 Value principles touch every corner of the business 168 The firm's objective 168 Strategic business unit management 170 Strategic assessment ^ 172 Strategic choice 180
Strategy implementation What use is the head office? Targets and motivation Notes 8 Measures of value creation Using cash flow to measure value Shareholder value analysis Economic profit Economic value added (EVA ) Notes 9 Entire firm value measurement Total shareholder return (TSR) Wealth Added Index (WAI) Market Value Added (MVA) Excess return (ER) Market to book ratio (MBR) Notes 10 What is the company's cost of capital? A word of warning The required rate of return Two sides of the same coin The weighted average cost of capital (WACC) The cost of equity capital The cost of retained earnings The cost of debt capital The cost of preference share capital Hybrid securities Calculating the weights The WACC with three or more types of finance Classic error What about short-term debt? Applying the WACC to projects and SBUs What do managers actually do? Pre-tax and post-tax WACC Implementation issues CONTENTS 181 181 187 188 188 189 190 190 196 205 213 215 215 219 220 221 224 227 231 232 234 234 235 236 236 237 238 239 245 257 257 260 261 261 262 262 263 263 264 268 271 VII
VIII CONTENTS Which risk-free rate? 273 Fundamental beta 276 Some thoughts on the cost of capital 277-279 Notes 279 11 Mergers: impulse, regret and success 281 282 The merger decision 282 You say acquisition, I say merger 283 Merger statistics 285 What drives firms to merge? 288 Do the shareholders of acquiring firms gain from mergers? 302 Managing mergers 305 314 Websites 314 Notes 314 12 The merger process 317 318 The City Code on Takeovers and Mergers 320 Action before the bid. 326 The bid 326 After the bid 326 Defence tactics 327 Paying for the target's shares 329 335 Websites. 335 Notes, 336 13 Valuing companies 337 338 The two skills 338 Valuation using net asset value (NAV) 339 Income flow is the key 344 Dividend valuation methods 345 How do you estimate future growth? 352 Price-earnings ratio (PER) model 353 Valuation using cash flow 362 Valuing unquoted shares 370 Unusual companies 371 Managerial control changes the valuation 372 381 Notes 381
CONTENTS 14 What pay-outs should we make to shareholders? 383 384 Defining the problem 384 Theorists in their hypothetical world 385 The other extreme - dividends as a residual 388 What about the world in which we live? 388 Some muddying factors 391 Scrip dividends 398 Share buy-backs and special dividends 399 A round-up of the arguments 402 404 Notes 405 SECTION III: FINANCE RAISING 15 Debt finance available to firms of all sizes 409 Contrasting debt finance with equity Bank borrowing Overdraft Term loans Revolving credit facility Trade credit.' Factoring Hire purchase Leasing Bills of exchange Acceptance credits (bank bills or banker's acceptance) Websites Notes Debt finance from the financial markets Bonds Syndicated loans Credit rating Mezzanine debt and high-yield (junk) bonds Convertible bonds Valuing bonds International sources of debt finance Medium-term notes (MTNs) Commercial paper Project finance Sale and leaseback Securitization 410 411 414 418 422 424 424 429 434 436 443 444 445 446 446 447 448 449 454 455 459 463 467 471 478 481 482 485 487 489 IX
CONTENTS Websites 490 Notes 490 17 Raising equity capital 491 493 What is equity capital? 494 Preference shares 497 Floating on the Main Market (Official List) 499 What managers need to consider 500 Methods of issue 506 Timetable for a new issue (initial public offering, IPO) 509 How does an alternative investment market (AIM) flotation differ from one on the Official List? 512 The costs of new issues 515 Rights issues 518 Other equity issues 524 Scrip issues 527 Warrants 528 Equity finance for unquoted firms 528 Private equity categories 536 Disillusionment and dissatisfaction with quotation 536 " 536 Websites 537 Appendix 17.1 Arguments for and against floating 538 Notes 538 SECTION IV: MANAGING RISK 18 The financial risks managers have to deal with 543 544 Types of risk ' 545 Risk in the financial structure 550 The dangers of gearing 558 What do we mean by gearing? 558 Agency costs 571 Pecking order 572 Some further thoughts on debt finance 576 Rounding up the capital structure arguments 578 581 Websites 581 Notes 582 19 Options 583 584 What is a derivative? 584 A long history 585
CONTENTS What is an option? 586 Share options 586 Index options 597 Corporate uses of options 599 Real options 600 601 Websites 602 Notes 602 XI 20 Using futures, forwards and swaps to manage risk 603 604 Futures 604 Short-term interest rate futures 614 Forwards 620 Forward rate agreements (FRAs) 621 A comparison of options, futures and FRAs 622 Caps 622 Swaps 625 Derivatives users 629 Over-the-counter (OTC) and exchange-traded derivatives 631 633 Websites? 633 Notes /' 634 21 Managing exchange-rate risk 635 636 The impact of currency rate changes on the firm 637 Volatility in foreign exchange 638 The currency markets 640 Exchange rates. 641 Covering in the forward market 645 Types of foreign-exchange risk 648 Transaction risk strategies 651 Managing translation risk 664 Managing economic risk 665 666 Websites 667 Notes 667 Appendix I Future value of 1 at compound interest 669 Appendix II Present value of 1 at compound interest 670 Appendix III Present value of an annuity of 1 at compound interest 671 Appendix IV Future value of an annuity of 1 at compound interest 672 Glossary 673 Further reading 743 Index 771