GLEN ARNOLD BSc (E con), PhD CORPORATE FINANCIAL MANAGEMENT FIFTH EDITION PEARSON Harlow, England London New York Boston San Francisco Toronto Sydney * Auckland * Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town Sao Paulo Mexico City Madrid Amsterdam Munich Paris Milan
Topics covered in the book Introduction to the book Guided tour Guided tour of MyFinanceLab Acknowledgements XXI xxiii xxxi xxxiv xxxvii Part 1 Introduction 1 The financial world Learning outcomes Introduction The objective of the firm Case study 1.1 Xstrata pic Some possible objectives Corporate governance Primitive and modern economies The role of the financial manager The flow of funds and financial intermediation Growth in the financial services sector The financial system Concluding comments Key points and concepts References and further reading Case study recommendations Websites Self-review questions Questions and problems Assignments 2 3 3 3 5 16 22 24 27 33 36 41 42 43 46 46 46 47 48 Part 2 The investment decision 2 Project appraisal: net present value and internal rate of return Learning outcomes Introduction Value creation and corporate investment Net present value and internal rate of return Modified internal rate of return Concluding comments Key points and concepts 49 50 50 57 52 56 75 78 79
Appendix 2.1 Mathematical tools for finance 79 Mathematical tools exercises 86 References and further reading 87 Case study recommendations 88 Websites 88 Self-review questions 88 Questions and problems 88 Assignments 91 Project appraisal: cash flow and applications 92 Learning outcomes 92 Introduction. 93 Case study 3.1 Airbus's superjumbo 93 Quality of information 94 Are profit calculations useful for estimating project viability? 95 The replacement decision 107 Replacement cycles 107 When to introduce a new machine 114 Drawbacks of the annual equivalent annuity method 115 Timing of projects - 115 The make or buy decision 116 Fluctuating output 117 Concluding comments 119 Key points and concepts 119 References and further reading 119 Case study recommendations 120 Self-review questions 120 Questions and problems 121 Assignments 127 The decision-making process for investment appraisal 128 Learning outcomes 128 Introduction 129 Evidence on the employment of appraisal techniques 130 Payback 130 Accounting rate of return 133 Internal rate of return: reasons for continued popularity 136 The managerial 'art' of investment appraisal 137 The investment process 141 Concluding comments 147 Key points and concepts 147 References and further reading 148 Case study recommendations 150 Self-review questions 151 Questions and problems 757 Assignments 153
xi Project appraisal: capital rationing, taxation and inflation 154 Learning outcomes 154 Introduction ^ 155 Capital rationing * 155 Taxation and investment appraisal 159 Inflation 162 Case study 5.1 Eurotunnel's inflation allowance 163 Concluding comments 168 Key points and concepts 168 References and further reading 169 Case study recommendations 169 Self-review questions 169 Questions and problems 170 Assignments 7 74 Part 3 Risk and return 175 6 Risk and project appraisal 176 Learning outcomes. 176 Case study 6.1 Two risky ventures... 177 Introduction 177 What is risk? 177 Adjusting for risk through the discount rate 180 Sensitivity analysis 180 Scenario analysis 185 Probability analysis 187 The risk of insolvency 197 Problems of using probability analysis 202 Evidence of risk analysis in practice 203 Real options (managerial options) 203 Concluding comments 213 Key points and concepts 213 References and further reading 214 Case study recommendations 215 Self-review questions 216 Questions and problems 216 Assignments 221 Portfolio theory 222 Learning outcomes 222 Introduction 223 Holding period returns 223 Expected return and standard deviation for shares 225 Combinations of investments 228 Portfolio expected return and standard deviation 235 Dominance and the efficient frontier - 239 Indifference curves 243 Choosing the optimal portfolio 245 The boundaries of diversification 246 Extension to a large number of securities : 248 Evidence on the benefits of diversification. 249
xii Contents The capital market line 253 Problems with portfolio theory 256 Concluding comments 259 Key points and concepts 260 References and further reading 261 Case study recommendations 262 Self-review questions 262 Questions and problems 263 Assignments 267 8 The Capital Asset Pricing Model and multi-factor models 268 Learning outcomes 268 Introduction 269 Some fundamental ideas and problems 270 A short history of shares, bonds and bills 272 The Capital Asset Pricing Model 283 { Factor models 302 The arbitrage pricing theory 305 The three-factor model 306 Fundamental beta 307 { Project appraisal and systematic risk 308 \ Sceptics' views - alternative perspectives on risk 309 j Concluding comments 312 \ Key points and concepts 313 \ Appendix 8.1 Note on arithmetic and geometric means 314 { Appendix 8.2 Why professors do or do not use CAPM-beta 315 f References and further reading 323 r Case study recommendations 326 f Self-review questions 326 f Questions and problems 327 j Assignments 328 \ Part 4 Sources of finance 329 9 Stock markets 330 Learning outcomes j 330 Case study 9.1 Using the stock market both to create wealth and to treat disease 331 Introduction 331 Stock exchanges around the world 331 Globalisation of financial flows 337 Why do companies list their shares on more than one exchange? 338 The importance of a well-run stock exchange 341 The London Stock Exchange 343 The UK equity markets available to companies 347 Tasks for stock exchanges 349 How stock exchanges work 350 The ownership of UK shares 356 Regulation 358 Understanding the figures in the financial pages : 360 Taxation and corporate finance 363
xiii Concluding comments 363 Key points and concepts 364 References and further reading 365 Case study recommendations * 366 Websites 366 Video presentations 366 Self-review questions 366 Questions and problems 367 Assignments " 367 10 Raising equity capital 368 Learning outcomes 368 Case study 10.1 To float or not to float? 369 Introduction 369 What is equity capital? 370 Preference shares 373 Some unusual types of shares 375 Floating on the Main Market (Official List) 376 Methods of issue 382 Timetable for a new issue (initial public offering) - 384 How does an AIM flotation differ from one on the Official List? 386 The costs of new issues 387 Rights issues 389 Other equity issues 395 Scrip issues 397 Warrants 398 Equity finance for unquoted firms 398 How independent private fund is established and managed 404 Disillusionment and dissatisfaction with quotation 411 Concluding comments 412 Key points and concepts 412 Appendix 10.1 Reasons for and against floating 415 References and further reading 421 Case study recommendations 422 Websites 422 Video presentations 423 Self-review questions 423 Questions and problems. 424 Assignment» 425 11 Long-term debt finance 426 Learning outcomes 426 Introduction. 427 Some fundamental features of debt finance 428 Bonds 428 Bank borrowing 431 Syndicated loans, 434 Credit rating 435 Mezzanine finance and high-yield (junk) bonds 437 Case study 11.1 The junk bond wizard: Michael Milken 440 Convertible bonds 442
Valuing bonds 445 International sources of debt finance 449 Project finance 458 Sale and leaseback 459 Securitisation 462 Islamic banking 464 The term structure of interest rates 465 Concluding comments 468 Key points and concepts 468 References and further reading 470 Case study recommendations 471 Websites 471 Video presentations 471 Self-review questions 472 Questions and problems 472 Assignments 474 12 Short-term and medium-term finance 475 Learning outcomes, 475 Introduction 476 Short- and medium-term bank finance 477 Trade credit 480 Factoring 483 Case study 11.1 Prestige pet products 484 Hire purchase 487 Leasing 489 Bills of exchange 494 Acceptance credits (bank bills or banker's acceptance) 495 Treasury management 496 { Financing 498 f Risk management 506 Working capital management 510 Investment of temporary surplus funds 527 Concluding comments 530 Key points and concepts 531 References and further reading 533 Case study recommendations 534 Websites 534 Video presentations -. * 535 Self-review questions 535 Questions and problems 541 Assignments 13 Stock market efficiency 542 Learning outcomes 542 Introduction 543 What is meant by efficiency? 543 Random walks - 547 The three levels of efficiency 549 Weak-form tests 549 Semi-strong form tests 557
Strong-form tests 577 Behavioural finance 579 Misconceptions about the efficient market hypothesis 586 Implications of the EMH for investors v 587 Implications of the EMH for companies 587 Concluding comments 588 Key points and concepts 589 References and further reading 590 Case study recommendations 599 Self-review questions 599 Questions and problems 600 Assignment 601 Part 5 Corporate value 603 14 Value-based management 604 Learning outcomes 604 Introduction 605 Case study 14.1 Compass group 607 The shareholder wealth-maximising goal 608 Three steps of value 610 Earnings-based management 610 Return on capital employed (ROCE) has failings 615 How a business creates value 617 An overview of the application of value principles 624 Strategic business unit management 626 Corporate strategy 634 Targets and motivation, 638 Case study 14.4 Strategy, planning and budgeting at Lloyds TSB 639 Concluding comments 639 Key points and concepts 640 References and further reading 643 Video presentations 644 Case study recommendation 644 Self-review questions 644 Questions and problems 645 Assignment 647 15 Value-creation metrics 648 Learning outcomes 648 Introduction 649 Using cash flow to measure value 650 Shareholder value analysis 654 Economic profit 662 Economic value added (EVA ) 668 Total shareholder return (TSR). 670 Wealth Added Index (WAI) 672 Market Value added (MVA) 673 Excess return (ER) ; 676 Market to book ratio (MBR) 678
xvi Contents Concluding comments 680 Key points and concepts 681 References and further reading. 684 Case study recommendations 685 Website 685 Self-review questions 685 Questions and problems 686 Assignments 688 16 The cost of capital 691 Learning outcomes 691 Introduction 692 A word of warning 692 The required rate of return 692 The weighted average cost of capital (WACC) 694 The cost of equity capital 700 The cost of retained earnings 702 The cost of debt capital 702 The cost of preference share capital 704 Calculating the weights 704 Applying the WACC to projects and SBUs 706 Empirical evidence of corporate practice 707 How large is the equity risk premium 711 Some thoughts on the cost of capital 714 Concluding comments 715 Key points and concepts 716 References and further reading 716 Case study recommendations 718 Websites ' 718 Video presentations 719 Self-review questions 719 Questions and problems 719 Assignment 721 17 Valuing shares 722 Learning outcomes 722 Introduction > 723 Casestudy17.1Amazon.com 723 Valuation using net asset value (NAV) 724 Valuation using income-flow methods 727 The dividend valuation models 728 The price-earnings ratio (PER) model 736 Valuation using cash flow 741 Valuation using owner earnings 744 EBITDA 747 Valuing unquoted shares 749 Unusual companies 751 Managerial control and valuation 752 Allowing for real option values 755 Concluding comments ' 760 Key points and concepts 760
xvii References and further reading Case study recommendations Websites Self-review questions Questions and problems Assignments 762 763 763 763 764 770 18 Capital structure Learning outcomes Introduction Case study 18.1 The balance between debt and ordinary share capital What do we mean by 'gearing'? The effect of gearing The value of the firm and the cost of capital Does the cost of capital (WACC) decrease with higher debt levels? Modigliani and Miller's argument in a world with no taxes The capital structure decision in a world with tax Additional considerations Some further thoughts on debt finance Concluding comments Key points and concepts Appendix 18.1 Asset beta Appendix 18.2 Adjusted present value (APV) References and further reading Case study recommendations Video presentations Self-review questions Questions and problems Assignments 771 777 772 773 774 780 785 785 787 790 793 804 806 809 810 812 813 816 816 817 817 819 19 Dividend policy Learning outcomes Introduction Defining the problem Miller and Modigliani's dividend irrelevancy proposition Dividends as a residual Clientele effects Taxation. " Dividends as conveyors of information Resolution of uncertainty Owner control (agency theory) Scrip dividends Share buy-backs and special dividends A round-up of the arguments' Concluding comments Key points and concepts References and further reading Case study recommendations Video presentations Self-review questions Questions and problems Assignments 820 820 821 821 823 825 827 829 829 832 833 834 835 839 840 841 842 844 844 844 845 848
xviii Contents 20 Mergers 849 Learning outcomes 849 Introduction 850 The merger decision * 850 Definitions and semantics 851 Merger statistics 852 Merger motives 853 Case study 20.1 Economies of scale in oil 858 Financing mergers 867 The merger process 873 The impact of mergers. 880 Managing mergers 884 Concluding comments 896 Key points and concepts 896 References and further reading 898 Case study recommendations 901 Websites 902 Video presentations 902 Self-review questions 902 Questions and problems 903 Assignment. 905 Part 6 Managing risk 907 21 Derivatives ' 908 Learning outcomes -908 Introduction 909 A long history 909 Options 910 Forwards 919 Futures 921 Forward rate agreements (FRAs) 933 A comparison of options, futures, forwards and FRAs 933 Caps 935 Swaps 937 Derivatives users. 940 Over-the-counter (OTC) and exchange-traded derivatives 941 Concluding comments 942 Key points and concepts " 943 Appendix 21.1 Option pricing 944 Appendix 21.2 The relationship between FRAs and swaps 945 References and further reading 948 Case study recommendations 948 Websites 949 Self-review questions 949 Questions and problems 950 Assignments 953 22 Managing exchange-rate risk 954 Learning outcomes. 954 Introduction 955
xix Case study 22.1 What a difference a few percentage point moves on the exchange rate make 955 The effects of exchange-rate changes 956 Volatility in foreign exchange % 957 The foreign exchange markets 959 Exchange rates. 961 Types of foreign-exchange risk 965 Transaction risk strategies 968 Managing translation risk 977 Managing economic risk 979 Exchange-rate determination 980 Concluding comments 986 Key points and concepts 987 References and further reading 987 Case study recommendations 988 Websites 989 Self-review questions 989 Questions and problems 990 Assignments 992 APPENDICES A:I I Future value of 1 at compound interest A:2 II Present value of 1 at compound interest A:3 III Present value of an annuity of 1 at compound interest A:4 IV Future value of an annuity of 1 at compound interest A:5 V Areas under the standardised normal distribution A:6 VI Answers to the mathematical tools exercises in Chapter 2, Appendix 2.1 A:7 Glossary C:7 Bibliography B:1 Index 1:1