THE HANDBOOK OF CORPORATE FINANCE
Arnold ppr flaps 17/09/2005 07:40 AM Page 1He has published work directed at a full range of readership,from refereed journal articles directed at fellow academics tointroductory finance and investment for the complete novice.His textbook Corporate Financial Management (first publishedin 1998, now in its second edition) has quickly established itsplace as the leading UK-based textbook for undergraduates,postgraduates and post-experience students. It is noted for itsextremely readable style embedded in real-world practice as wellas robust theory. The book Valuegrowth Investing, directed atexperienced investors is again written in a very approachable andstraightforward manner.THE HANDBOOK OFCORPORATE FINANCEA Business Companion to Financial Markets, Decisions and TechniquesThe imperatives of modern business mean that, sooner or later, everyexecutive will have to get to grips with finance. Its terms, its tools,GLEN ARNOLDTHE HANDBOOK OFCORPORATE FINANCEA Business Companion to FinancialMarkets, Decisions and TechniquesIn what projects will we best invest our shareholders money?How do we create and measure shareholder value?THE HANDBOOK OFCORPORATE FINANCEA Business Companion to Financial Markets, Decisions and TechniquesWhat type of finance should we raise?How can we measure and manage financial risk?These are challenges that every business faces, and questionsthat every executive will encounter. Knowing the answers tothese questions will help you and your business to back the rightchoices, make the right decisions and deliver improved financialperformance.which capital expenditure projects are worthy of backing for tomorrow,These are the questions that The Handbook of Corporate Financehas been built to answer. Step-by-step, it will explain theprinciples and practices of corporate finance and the financialmarkets, with an emphasis on the terms you need to understandand the tools and techniques you need to apply. Directed firmly atsounder judgment and sharper decision-making, it will guide youthrough key issues as it:to the immediate and daily challenge of managing business units for provides a thorough grounding in value-based management;its techniques.Corporate finance touches every aspect of your business: from decidingthe language of corporate decision-makers. Fluency in finance will serveyou and your business well.The Handbook of Corporate Finance is the authoritative, comprehensiveand crystal-clear companion to business finance. examines the essentials of mergers and acquisitions, and inparticular, explores remedies for the problem of merger failure explores and explains the proper business use of derivativesas tools to help control risk, rather than increase it introduces modern investment appraisal techniques, andcontrasts their application with frequently employed “rulesof thumb” provides an overview of modern financial markets andinstruments, with insights into the benefits brought byeffective exploitation of those markets and perils of ignoringthe needs of the finance providers.The Handbook of Corporate Finance is here to help you tounderstand and apply the essentials of corporate finance withspeed and confidence.Visit our website atwww.pearson-books.comVisit our website ISBN 0-273-68851-0An imprint of Pearson Educationa frequently talked about but little understood conceptGLEN ARNOLDshareholder value. Finance is the framework for corporate decisions andpearson-books.com – who to read, what to know and where togo in the world of finance. Find out more about the people andideas that can make you and your finances more effective.THE HANDBOOK OFGLEN ARNOLDCORPORATE FINANCEProfessor Glen Arnold, PhD. is a professor of finance at SalfordUniversity and director of the Finance, Accounting and BankingResearch Interest Group.Front Cover Photograph: Stone/Getty Images9 780273 688518
HANDBOOK OFCORPORATE FINANCE
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HANDBOOK OFCORPORATE FINANCEA business companion to financial markets,decisions & techniquesGlen Arnold
PEARSON EDUCATION LIMITEDEdinburgh GateHarlow CM20 2JETel: 44 (0)1279 623623Fax: 44 (0)1279 431059Website: www.pearsoned.co.ukFirst published in Great Britain in 2005 Pearson Education Limited 2005The right of Glen Arnold to be identified as author of this work has been assertedby him in accordance with the Copyright, Designs and Patents Act 1988.ISBN 0 273 68851 0British Library Cataloguing-in-Publication DataA catalogue record for this book is available from the British LibraryLibrary of Congress Cataloging-in-Publication DataArnold, Glen.Handbook of corporate finance / Glen Arnold.p. cm. -- (Corporate finance)Includes bibliographical references and index.ISBN 0-273-68851-01. Corporations--Finance--Handbooks, manuals, etc. 2.Corporations--Management--Handbooks, manuals, etc. I. Title. II. Corporate finance(Financial Times Prentice Hall)HG4027.3.A76 2004658.15--dc222004049704All rights reserved. No part of this publication may be reproduced, stored in a retrievalsystem, or transmitted in any form or by any means, electronic, mechanical,photocopying, recording or otherwise, without either the prior written permission of thepublishers or a licence permitting restricted copying in the United Kingdom issued by theCopyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP. This book maynot be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding orcover other than that in which it is published, without the prior consent of the publishers.This publication is designed to provide accurate and authoritative information in regard tothe subject matter covered. It is sold with the understanding that neither the authors nor thepublisher is engaged in rendering legal, investing, or any other professional service. If legal adviceor other expert assistance is required, the service of a competent professional person should be sought.The publisher and contributors make no representation, express or implied, with regard to theaccuracy of the information contained in this book and cannot accept any responsibility or liabilityfor any errors or omissions that it may contain.10 9 8 7 6 5 4 3 2 109 08 07 06 05Typeset in 10/13 pt CentITC by 30Printed and bound in Great Britain by Bell & Bain Ltd, GlasgowThe publisher’s policy is to use paper manufactured from sustainable forests.
CONTENTS123About the authorxiiiAcknowledgmentsxivAuthor’s AcknowledgmentsxvIntroductionxviWhat is the firm’s objective?1IntroductionA common purposeThe assumed objective for financeWhat is shareholder value?Profit maximization is not the same as shareholderwealth-maximizationGetting manager’s objectives aligned with those of shareholdersWhat happens if control over directors is weak?Conclusion2271112151920SECTION I: INVESTING IN PROJECTSState-of-the-art project appraisal techniques23IntroductionHow do you know if an investment generates value for shareholders?State-of-the-art technique 1: net present valueState-of-the-art technique 2: internal rate of returnChoosing between NPV and IRRConclusionAppendix 2.1 Mathematical tools for finance23253039474950Traditional appraisal techniques61IntroductionWhat appraisal techniques do businesses use?PaybackAccounting rate of returnInternal rate of return: reasons for continued popularityConclusion626262677071
VICONTENTS4567Investment decision-making in companies73IntroductionThe managerial art of investment selectionMore tricky issues in real world project appraisalThe stages of investment decision-makingConclusion7475828592Allowing for risk in project appraisal93IntroductionWhat is risk?Adjusting for risk through the discount rateSensitivity analysisScenario analysisProbability analysisProblems with using probability analysisEvidence of risk analysis in practiceConclusion95959898104106112113113SECTION II: SHAREHOLDER VALUEValue managed vs earnings managed companies117IntroductionThe pervasiveness of the value approachCase studies: FT100 companies creating and destroying valueWhy shareholder value?Three steps to valueEarnings-based management’s failingsReturn on capital employed has failingsFocussing on earnings is not the same as valueHow a business creates valueThe five actions for creating lue through strategy145IntroductionValue principles touch every corner of the businessThe firm’s objectiveStrategic business unit managementStrategic assessmentStrategic choiceStrategy implementationWhat use is the head office?Targets and motivationConclusion146146146148150158159159162164
CONTENTS89Measures of value creation165IntroductionUsing cash flow to measure valueShareholder value analysisEconomic profitEconomic value addedCash flow return on investmentConclusion166166172181189191191Entire firm value measurement195IntroductionTotal shareholder returnWealth Added IndexMarket Value AddedMarket to Book RatioConclusion19619720020420820910 What is the company’s cost of capital?IntroductionA word of warningThe required rate of returnTwo sides of the same coinThe weighted average cost of capitalThe cost of equity capitalThe cost of retained earningsThe cost of debt capitalThe cost of preference share capitalHybrid securitiesCalculating the weightsThe WACC with three or more types of financeClassic errorWhat about short-term debt?Applying the WACC to projects and SBUsWhat do managers actually do?Implementation issuesWhich risk-free rate?Fundamental betaSome thoughts on the cost of 236237237238238239243245248249251VII
VIIICONTENTS11 Mergers: Impulse, regret and successIntroductionThe merger decisionYou say acquisition, I say mergerMerger statisticsWhat drives firms to merge?Do the shareholders of acquiring firms gain from mergers?Managing mergersConclusion12 The merger processIntroductionThe City Code on Takeovers and MergersAction before the bidThe bidAfter the bidDefense tacticsPaying for the target’s sharesConclusion13 Valuing companiesIntroductionThe two skillsValuation using net asset valueIncome flow is the keyDividend valuation methodsHow do you estimate future growth?Price earnings ratio-to-modelValuation using cash flowValuing unquoted sharesUnusual companiesManagerial control changes the valuationConclusion14 What pay-outs should we make to shareholders?IntroductionDefining the problemTheorists in their hypothetical worldThe other extreme – dividends as a residualWhat about the world in which we live?Some muddying factorsScrip 45347348348349352352354360
CONTENTSShare buy-backs and special dividendsA round-up of the argumentsConclusionSECTION III: FINANCE RAISING15 Debt finance available to firms of all sizesIntroductionContrasting debt finance with equityBank borrowingOverdraftTerm loansTrade creditFactoringHire purchaseLeasingBills of exchangeAcceptance credits (bank bills or banker’s 238639139339940140216 Debt finance from the financial markets403IntroductionBondsSyndicated loansCredit ratingMezzanine debt and high-yield (junk) bondsConvertible bondsValuing bondsInternational sources of debt financeMedium-term notesCommercial paperProject financeSale and 042442844144244344544744817 Raising equity capitalIntroductionWhat is equity capital?Preference sharesFloating on the official listWhat managers need to considerMethods of issue451453454456459460466IX
XCONTENTSTimetable for a new offerHow does an alternative investment market flotation differfrom one on the official list?The costs of new issuesRights issuesOther equity issuesScrip issuesWarrantsEquity finance for unquoted firmsDisillusionment and dissatisfaction with quotationConclusionAppendix 17.1 Arguments for and against floatingSECTION IV: MANAGING RISK18 The financial risks managers have to deal on510Types of riskRisk in the financial structureThe dangers of gearingWhat do we mean by gearing?Agency costsPecking orderSome further thoughts on debt financeConclusion51151452152353453653854419 OptionsIntroductionWhat is a derivative?A long historyWhat is an option?Share optionsIndex optionsCorporate uses of optionsReal optionsConclusion20 Using futures, forwards and swaps to manage riskIntroductionFuturesShort-term interest rate futuresForwardsForward rate 76580583
CONTENTSA comparison of options, futures and FRAsCapsSwapsDerivatives usersOver-the-counter and exchange-traded derivativesConclusion21 Managing exchange-rate risk584584586589592593595IntroductionThe impact of currency rate changes on the firmVolatility in foreign exchangeThe currency marketsExchange ratesCovering in the forward marketTypes of foreign-exchange riskTransaction risk strategiesManaging translation riskManaging economic endices I–IIIGlossaryFurther readingIndex629633687703XI
To Ben, Sam, Poppy and George
ABOUT THE AUTHORGlen Arnold, PhD. is a professor of finance (part time) at the University ofSalford. He heads a research team focussed on stock market mispricing ofshares and the exploitation of that mispricing. His university textbookCorporate Financial Management has quickly established its place as the leading UK-based textbook for undergraduates and post-graduates. He also wroteThe Financial Times Guide to Investing, which provides a comprehensiveintroduction to investment and the financial markets. The book ValuegrowthInvesting, describes the approaches of the great investors and synthesizes theirinsights into a disciplined form of investing.
A C K N OW L E D G M E N T SWe are grateful to the following for permission to reproduce copyright material:Case Study 1.1 and Exhibit 2.1 from the Cadbury Schweppes Annual Report andForm 20-F 2002 and Report and Accounts 2002; Case Study 7.1 from Arnold, G.G.and Davies, M. (eds) (2000) Value Based Management, London: Wiley; Table 10.2from Dimson, E., Marsh, P. and Staunton, M. (2002) Trumph of the Optimists: 101Years of Global Investment Returns, Princeton, NJ: Priceton University Press;Table 16.4 from the BIS Bank of International Settlements Quarterly Review,December 2003. Figures 11.2, 13.4 and Appendices I–IV from Arnold, G. CorporateFinancial Management, London: Financial Times Prentice Hall. Extracts throughout from the Financial Times. Reproduced with permission.Exhibits 11.5, 11.9, 12.5 and 14.1 and text extracts on pages 149, 335, 348, 353are quoted from Berkshire Hathaway Annual Reports and accompanying lettersto shareholders, reproduced with the kind permission of Warren Buffett.In some instances we have been unable to trace the owners of copyright material, and we would appreciate any information that would enable us to do so.
A U T H O R ’ S A C K N OW L E D G M E N T SThis book draws on the talents, knowledge and contributions of a great manypeople. I would especially like to thank the following:Warren Buffett who kindly assisted the illustration of key points by allowing theuse of his elegant, insightful and witty prose. Dr Mike Staunton and ProfessorsElroy Dimson and Paul Marsh of the London Business School who granted permission to present some important data.The Financial Times writers who provided so many useful illustrative articles,and who, on a day to day basis, deepen my understanding of finance.The team at Pearson Education (FT Prentice Hall) who, at various stages, contributed to the production of the book: Paula Devine, Laurie Donaldson, JulieKnight, Colin Owens, Lisa Reading, Kate Salkilld, Richard Stagg, Kim Harris andLiz Wilson.
INTRODUCTIONManagers climbing the corporate ladder find the further they go the more theyneed to understand the concepts and jargon of finance, both for internal decision making and external interaction with investors, bankers and the City.It is normally the case that managers have not received any formal training infinance. Furthermore, they are not in a position to take time out from the business to dedicate themselves to study. So what they need is a guide that willallow them to absorb and apply the essential tools of finance while they continue with their executive responsibilities. This book is that guide.It is designed to be comprehensive, crystal-clear and directed at real worldproblem solving. It is rigorous without over-burdening the reader. It is not academic in the sense of laboriously expounding theory, but it nevertheless presentsstate-of-the-art techniques and frameworks, with a focus on managerial action.The imperatives of day-to-day management meanthat all middle and senior executives must have a firmThe imperatives of day-to-daygrasp of the fundamental financial issues. These willmanagement mean that allmiddle and senior executivestouch every aspect of the business, ranging frommust have a firm grasp of thedeciding which capital expenditure projects arefundamental financial issues.worthy of backing to managing business units forshareholder value.Discussion at boardroom level – which inevitably percolates down – is mostlycouched in financial terms: what rate of return are we achieving? should we merge?how do we value a company? how do we control foreign exchange rate losses? etc.Because the language of business is largely financial, managers need to understandthat language if they want to know what is going on, and to advance. They also needto read the financial pages of broadsheet newspapers to comprehend the widerenvironment in which the business operates. How can they expect to make seniorlevel decisions without understanding the world around them? Newspapers such asthe Financial Times assume knowledge of key financial concepts and jargon. Thisbook will help with intelligent reading of these publications.Some of the financial issues covered Value-based management is increasingly spoken of, but little understood.This book provides a thorough grounding. Mergers and the problem of merger failure (i.e. acquiring shareholderslosing out) is discussed along with remedies.
INTRODUCTION The proper use of derivatives as tools helping the business control risk, ratherthan increasing it, is explained in easy-to-follow and practically-oriented fashion. Modern investment appraisal techniques are contrasted with the traditionalrules of thumb employed by many companies. There is an overview of modern financial markets and instruments withinsight into the benefits brought by effective exploitation of the markets andperils of ignoring the demands of the finance providers.The scope of corporate financeTo bring the book alive for readers, and to show the mutual reinforcement ofpractical management and finance theory, there are numerous examples ofmajor UK companies employing the concepts and techniques discussed in eachchapter. Much of the ‘real-world’ material is drawn from articles in theFinancial Times. A typical case is shown in Exhibit I.1 which is used here tohighlight t
the needs of the finance providers. The Handbook of Corporate Financeis here to help you to understand and apply the essentials of corporate finance with speed and confidence. Professor Glen Arnold, PhD.is a professor of finance at Salford University and director of the Finance, Accounting and Banking Research Interest Group.
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