Arnold ppr+flaps 17/09/2005 07:40 AM Page 1 Professor Glen Arnold,PhD. is a professor of finance at Salford GLEN ARNOLD CT GLEN ARNOLD THE HANDBOOK OF University and director of the Finance,Accounting and Banking H O CORPORATE FINANCE Research Interest Group. E R A Business Companion to Financial He has published work directed at a full range of readership, H from refereed journal articles directed at fellow academics to PA Markets, Decisions and Techniques introductoryfinance and investment for the complete novice. N THE HANDBOOK OF O D His textbook Corporate Financial Management (first published In what projects will we best invest our shareholders money? in 1998, now in its second edition) has quickly established its RB CORPORATE FINANCE place as the leading UK-based textbook for undergraduates, O How do we create and measure shareholder value? postgraduates and post-experience students. It is noted for its A O THE HANDBOOK OF extremely readable style embedded in real-world practice as well What type of finance should we raise? TK as robust theory. The book Valuegrowth Investing, directed at A Business Companion to Financial Markets, Decisions and Techniques CORPORATE FINANCE experienced investors is again written in a very approachable and EO How can we measure and manage financial risk? straightforward manner. F F These are challenges that every business faces,and questions A Business Companion to Financial Markets, Decisions and Techniques I that every executive will encounter. Knowing the answers to N these questions will help you and your business to back the right choices,make the right decisions and deliver improved financial The imperatives of modern business mean that, sooner or later, every A performance. executive will have to get to grips with finance. Its terms, its tools, N These are the questions that The Handbook of Corporate Finance its techniques. has been built to answer. Step-by-step, it will explain the C principles and practices of corporate finance and the financial markets,with an emphasis on the terms you need to understand E and the tools and techniques you need to apply. Directed firmly at Corporate finance touches every aspect of your business: from deciding sounder judgment and sharper decision-making,it will guide you which capital expenditure projects are worthy of backing for tomorrow, through key issues as it: to the immediate and daily challenge of managing business units for • provides a thorough grounding in value-based management; a frequently talked about but little understood concept shareholder value. Finance is the framework for corporate decisions and G • examines the essentials of mergers and acquisitions,and in the language of corporate decision-makers. Fluency in finance will serve L particular,explores remedies for the problem of merger failure E • explores and explains the proper business use of derivatives you and your business well. N as tools to help control risk,rather than increase it A • introduces modern investment appraisal techniques,and R contrasts their application with frequently employed “rules The Handbook of Corporate Finance is the authoritative, comprehensive N of thumb” • provides an overview of modern financial markets and O and crystal-clear companion to business finance. instruments,with insights into the benefits brought by L effective exploitation of those markets and perils of ignoring D the needs of the finance providers. Visit our website at The Handbook of Corporate Finance is here to help you to www.pearson-books.com understand and apply the essentials of corporate finance with speed and confidence. pearson-books.com – who to read, what to know and where to Visit our website at –––––––––––––––––––– go in the world of finance. Find out more about the people and www.pearson-books.com ––––––F–I–N–A––N–C––E–––––– ideas that can make you and your finances more effective. ISBN 0-273-68851-0 Front Cover Photograph: 9 780273 688518 An imprint of Pearson Education © Stone/Getty Images HANDBOOK OF CORPORATE FINANCE In an increasingly competitive world, we believe it’s quality of thinking that will give you the edge – an idea that opens new doors, a technique that solves a problem, or an insight that simply makes sense of it all. The more you know, the smarter and faster you can go. That’s why we work with the best minds in business and finance to bring cutting-edge thinking and best learning practice to a global market. Under a range of leading imprints, including Financial Times Prentice Hall, we create world-class print publications and electronic products bringing our readers knowledge, skills and understanding which can be applied whether studying or at work. To find out more about Pearson Education publications, or tell us about the books you’d like to find, you can visit us at www.pearsoned.co.uk HANDBOOK OF CORPORATE FINANCE A business companion to financial markets, decisions & techniques Glen Arnold PEARSON EDUCATION LIMITED Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 Website: www.pearsoned.co.uk First published in Great Britain in 2005 © Pearson Education Limited 2005 The right of Glen Arnold to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN 0 273 68851 0 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Arnold, Glen. Handbook of corporate finance / Glen Arnold. p. cm. -- (Corporate finance) Includes bibliographical references and index. ISBN 0-273-68851-0 1. Corporations--Finance--Handbooks, manuals, etc. 2. Corporations--Management--Handbooks, manuals, etc. I. Title. II. Corporate finance (Financial Times Prentice Hall) HG4027.3.A76 2004 658.15--dc22 2004049704 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover 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 to the subject matter covered. It is sold with the understanding that neither the authors nor the publisher is engaged in rendering legal, investing, or any other professional service. If legal advice or 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 the accuracy of the information contained in this book and cannot accept any responsibility or liability for any errors or omissions that it may contain. 10 9 8 7 6 5 4 3 2 1 09 08 07 06 05 Typeset in 10/13 pt CentITC by 30 Printed and bound in Great Britain by Bell & Bain Ltd, Glasgow The publisher’s policy is to use paper manufactured from sustainable forests. CONTENTS About the author xiii Acknowledgments xiv Author’s Acknowledgments xv Introduction xvi 1 What is the firm’s objective? 1 Introduction 2 A common purpose 2 The assumed objective for finance 7 What is shareholder value? 11 Profit maximization is not the same as shareholder wealth-maximization 12 Getting manager’s objectives aligned with those of shareholders 15 What happens if control over directors is weak? 19 Conclusion 20 SECTION I: INVESTING IN PROJECTS 2 State-of-the-art project appraisal techniques 23 Introduction 23 How do you know if an investment generates value for shareholders? 25 State-of-the-art technique 1: net present value 30 State-of-the-art technique 2: internal rate of return 39 Choosing between NPV and IRR 47 Conclusion 49 Appendix 2.1 Mathematical tools for finance 50 3 Traditional appraisal techniques 61 Introduction 62 What appraisal techniques do businesses use? 62 Payback 62 Accounting rate of return 67 Internal rate of return: reasons for continued popularity 70 Conclusion 71 VI CONTENTS 4 Investment decision-making in companies 73 Introduction 74 The managerial art of investment selection 75 More tricky issues in real world project appraisal 82 The stages of investment decision-making 85 Conclusion 92 5 Allowing for risk in project appraisal 93 Introduction 95 What is risk? 95 Adjusting for risk through the discount rate 98 Sensitivity analysis 98 Scenario analysis 104 Probability analysis 106 Problems with using probability analysis 112 Evidence of risk analysis in practice 113 Conclusion 113 SECTION II: SHAREHOLDER VALUE 6 Value managed vs earnings managed companies 117 Introduction 118 The pervasiveness of the value approach 118 Case studies: FT100 companies creating and destroying value 121 Why shareholder value? 123 Three steps to value 125 Earnings-based management’s failings 126 Return on capital employed has failings 133 Focussing on earnings is not the same as value 134 How a business creates value 134 The five actions for creating value 137 Conclusion 143 7 Value through strategy 145 Introduction 146 Value principles touch every corner of the business 146 The firm’s objective 146 Strategic business unit management 148 Strategic assessment 150 Strategic choice 158 Strategy implementation 159 What use is the head office? 159 Targets and motivation 162 Conclusion 164 CONTENTS VII 8 Measures of value creation 165 Introduction 166 Using cash flow to measure value 166 Shareholder value analysis 172 Economic profit 181 Economic value added 189 Cash flow return on investment 191 Conclusion 191 9 Entire firm value measurement 195 Introduction 196 Total shareholder return 197 Wealth Added Index 200 Market Value Added 204 Market to Book Ratio 208 Conclusion 209 10 What is the company’s cost of capital? 211 Introduction 212 A word of warning 212 The required rate of return 213 Two sides of the same coin 214 The weighted average cost of capital 215 The cost of equity capital 221 The cost of retained earnings 232 The cost of debt capital 232 The cost of preference share capital 236 Hybrid securities 236 Calculating the weights 236 The WACC with three or more types of finance 237 Classic error 237 What about short-term debt? 238 Applying the WACC to projects and SBUs 238 What do managers actually do? 239 Implementation issues 243 Which risk-free rate? 245 Fundamental beta 248 Some thoughts on the cost of capital 249 Conclusion 251 VIII CONTENTS 11 Mergers: Impulse,regret and success 253 Introduction 254 The merger decision 254 You say acquisition, I say merger 255 Merger statistics 257 What drives firms to merge? 259 Do the shareholders of acquiring firms gain from mergers? 272 Managing mergers 273 Conclusion 284 12 The merger process 287 Introduction 288 The City Code on Takeovers and Mergers 288 Action before the bid 290 The bid 294 After the bid 295 Defense tactics 296 Paying for the target’s shares 298 Conclusion 304 13 Valuing companies 307 Introduction 308 The two skills 308 Valuation using net asset value 309 Income flow is the key 314 Dividend valuation methods 314 How do you estimate future growth? 321 Price earnings ratio-to-model 324 Valuation using cash flow 330 Valuing unquoted shares 335 Unusual companies 336 Managerial control changes the valuation 339 Conclusion 345 14 What pay-outs should we make to shareholders? 347 Introduction 348 Defining the problem 348 Theorists in their hypothetical world 349 The other extreme – dividends as a residual 352 What about the world in which we live? 352 Some muddying factors 354 Scrip dividends 360 CONTENTS IX Share buy-backs and special dividends 360 A round-up of the arguments 361 Conclusion 364 SECTION III: FINANCE RAISING 15 Debt finance available to firms of all sizes 369 Introduction 370 Contrasting debt finance with equity 371 Bank borrowing 373 Overdraft 376 Term loans 382 Trade credit 382 Factoring 386 Hire purchase 391 Leasing 393 Bills of exchange 399 Acceptance credits (bank bills or banker’s acceptance) 401 Conclusion 402 16 Debt finance from the financial markets 403 Introduction 404 Bonds 405 Syndicated loans 409 Credit rating 410 Mezzanine debt and high-yield (junk) bonds 414 Convertible bonds 420 Valuing bonds 424 International sources of debt finance 428 Medium-term notes 441 Commercial paper 442 Project finance 443 Sale and leaseback 445 Securitization 447 Conclusion 448 17 Raising equity capital 451 Introduction 453 What is equity capital? 454 Preference shares 456 Floating on the official list 459 What managers need to consider 460 Methods of issue 466