Corporate Finance Principles & Practice

526 Pages·2011·4.65 MB·English

The material is covered in a way which is easy for students to understand…
The quality of the questions was sound and they were well-focused… C
fourth edition
References and recommended reading were some of the best I have encountered.
Penny Belk, Lecturer in Finance, Loughborough University Business School o
Corporate Finance
The very good case studies and the examples create suitable links between the theoretical r
concepts examined and real life cases.
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Dr Panagiotis Andrikopoulos, Senior Lecturer in Finance, Department of Acounting and Finance,
De Montfort University o
Principles & Practice
The fourth edition of Corporate Finance: Principles & Practice – now in full colour throughout – is a concise introduction to r
the core concepts and key topic areas of corporate fi nance. It offers integrated coverage of the three key decision areas in a
fi nance – investment, fi nancing and dividends – using a clear and logical framework for study and incorporates a wide range
of topical real-world examples, allowing students to relate theory to practice. This book provides the ideal structure for any t
corporate fi nance course, particularly where there are time constraints due to modular delivery.
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Corporate Finance: Principles & Practice is suitable for specialist and non-specialist corporate and business fi nance courses

at undergraduate, DMS and MBA/management at Masters level. Denzil Watson and Antony Head
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Key features
● Provides a student-friendly approach to the key topics in corporate fi nance. i
● Introduces appropriate tools and techniques for the fi nancial manager. n
● Vignettes featuring well-known companies to illustrate topics.
● Worked examples to consolidate learning points. a
● Wide range of question material, both for practice and group discussion.
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New features
● Full-colour format with an excellent range of features, including key points referenced throughout the text, to help student c
learning and development.
● Analysis of growing areas such as value management and shareholder value. e
● Questions that encourage critical thinking.
● A downloadable web supplement is available for lecturers and students at www.pearsoned.co.uk/watsonhead.
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Denzil Watson BA (Economics), MA (Money, Banking and Finance) and Antony Head BSc (Chemical Engineering), MBA, e
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PGCFHE are both Senior Lecturers in the Faculty of Organisation and Management at Sheffi eld Hallam University.
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They have extensive experience of teaching corporate fi nance, managerial fi nance and strategic fi nancial management il
in a wide range of courses at undergraduate, postgraduate and professional level. W
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The best aspect of the book is its accessibility and conciseness – o
unlike many books in the fi eld it is a readable text which gets the main points across quickly. n

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Kerry Sullivan, Senior Tutor Finance, School of Management, Surrey University n
d
Overall the book’s content is very well balanced, covering all the major areas within the corporate fi nance A
fi eld to a suitable depth and level for the intended audience. The writing style is also extremely engaging. n
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Richard Trafford, Senior Lecturer in Finance, Department of Accounting and Law, University of Portsmouth
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The book is of an appropriate level for students on the MBA course…They fi nd the content of the book is not too
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daunting and more importantly the book is of an appropriate length for a module of one semester.
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Mike Buckle, Senior Lecturer, School of Business and Economics, University of Swansea d
fourth
ISBN 0-273-70644-6 edition
cover photograph © Denzil Watson
9 780273 706441
www.pearsoned.co.uk/watsonhead www.pearson-books.com
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Corporate Finance
Principles & Practice
Visit the Corporate Finance: Principles & Practice,
fourth edition Companion Website at www.
pearsoned.co.uk/watsonhead to find valuable
student learning material including:
■ Multiple choice questions to help test your learning
■ Links to relevant sites on the web
CORF_A01.qxd 10/23/06 12:42 PM Page ii
We work with leading authors to develop the strongest
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fourth edition
Corporate Finance
Principles & Practice
Denzil Watson and Antony Head
Sheffield Hallam University
CORF_A01.qxd 10/23/06 12:42 PM Page iv
Tony would like to thank Aidan and Rosemary for their love
and courage, and dedicates this book to the memory of Lesley
Head (1952–2005), dear wife and mother.
Denzil would like to thank Dora, Hugh and Doreen for their
support and care.
Pearson Education Limited
Edinburgh Gate
Harlow
Essex CM20 2JE
England
and Associated Companies throughout the world
Visit us on the World Wide Web at:
www.pearsoned.co.uk
First edition published under the Financial Times Pitman Publishing imprint in 1998.
Second edition published under the Financial Times Prentice Hall imprint in 2001
Third edition published 2004
Fourth edition published 2007
© Pearson Education Limited 2007
The rights of Hugh Denzil Watson and Antony Head to be identified as authors of this work
have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.
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 publisher or a
licence permitting restricted copying in the United Kingdom issued by the Copyright
Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS.
All trademarks used herein are the property of their respective owners. The use of any
trademark in this text does not vest in the author or publisher any trademark ownership
rights in such trademarks, nor does the use of such trademarks imply any affiliation
with or endorsement of this book by such owners.
ISBN-13: 978-0-273-70644-1
ISBN-10: 0-273-70644-6
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
A catalogue record for this book is available from the Library of Congress
10 9 8 7 6 5 4 3 2 1
10 09 08 07 06
Typeset in 10/13pt Sabonby 73
Printed and bound by Graficas Estella, Bilbao, Spain
The publisher’s policy is to use paper manufactured from sustainable forests.
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Contents
Preface and acknowledgements xii
Guided tour of the book xiv
1 The finance function 1
LEARNING OBJECTIVES · INTRODUCTION
1.1 Two key concepts in corporate finance 2
1.2 The role of the financial manager 5
1.3 Corporate objectives 8
1.4 How is shareholder wealth maximised? 10
1.5 Agency theory 11
Vignette 1.1 Shrinking share options 16
1.6 Corporate governance 18
Vignette 1.2 Most companies ‘flout code on corporate governance’ 20
1.7 Conclusion 21
Vignette 1.3 Higgs review sets out boardroom code 22
Vignette 1.4 Bonuses undermining pay link with performance 23
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
2 Capital markets, market efficiency and ratio analysis 29
LEARNING OBJECTIVES · INTRODUCTION
2.1 Sources of business finance 30

2.2 Capital markets 33
2.3 Capital market efficiency 34
2.4 Assessing financial performance 41
Vignette 2.1 If only investors could compare like with like 44
2.5 Conclusion 58
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
3 Short-term finance and the management
of working capital 67
LEARNING OBJECTIVES · INTRODUCTION
3.1 The objectives of working capital management 68
3.2 Working capital policies 68
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Contents
3.3 Working capital and the cash conversion cycle 72
Example Calculating working capital required 72
3.4 Overtrading 74
3.5 The management of stock 75
Example Using the EOQ model 77
3.6 The management of cash 79
3.7 The management of debtors 82
Example Evaluating a change in debtor policy 84
Example Cost–benefit analysis of factoring 86
3.8 Conclusion 86
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
4 Long-term finance: equity finance 93
LEARNING OBJECTIVES · INTRODUCTION
4.1 Equity finance 94
4.2 The stock exchange 96
Vignette 4.1 IPOs the chosen route as equity markets advance 98
Vignette 4.2 Laura Ashley rights issue shunned 100
Vignette 4.3 Nightfreight to go private via £35m management buy-out 102
4.3 Rights issues 103
Example Calculation of the theoretical ex rights price 104
Example Wealth effect of a rights issue 105
Vignette 4.4 Opinions split on Pearson discounted rights issue 108
4.4 Scrip issues, share splits, scrip dividends and share repurchases 108
Vignette 4.5 3i shareholders to reap £500m 110
4.5 Preference shares 111
4.6 Conclusion 112
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
5 Long-term finance: debt finance, hybrid finance
and leasing 119
LEARNING OBJECTIVES · INTRODUCTION
5.1 Loan stock and debentures 120
Vignette 5.1 Bayer’s €2bn in convertibles 122
Vignette 5.2 Ahold looks for breathing space 124
Vignette 5.3 Hellas’ €500m Pik 125
Vignette 5.4 New issues: Denmark and VNU meet strong demand 126
5.2 Bank and institutional debt 126
Example Interest and capital elements of annual loan payments 126
5.3 International debt finance 127
5.4 Convertible bonds 128
Example Convertible bond terms 129
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Contents
5.5 Warrants 130
5.6 The valuation of fixed-interest bonds 131
Example Valuation of an irredeemable bond 132
Example Valuation of a redeemable bond with annual interest 132
Example Valuation of a redeemable bond with semi-annual interest 133
5.7 The valuation of convertible bonds 133
Example Valuation of a convertible bond 134
5.8 Leasing 136
Vignette 5.5 Leasing looks like a worthwhile option 139
Example Evaluation of leasing versus borrowing to buy 141
5.9 Conclusion 143
Vignette 5.6 Independent’s rights issue delivers a reality check 144
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
6 An overview of investment appraisal methods 152
LEARNING OBJECTIVES · INTRODUCTION
6.1 The payback method 153
6.2 The return on capital employed method 155
Example Calculation of the return on capital employed 156
6.3 The net present value method 158
Example Calculation of the net present value 159
6.4 The internal rate of return method 162
Example Calculation of internal rates of return 163
6.5 A comparison of the NPV and IRR methods 166
6.6 The profitability index and capital rationing 170
6.7 The discounted payback method 173
6.8 Conclusion 174
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
7 Investmen t appraisal: applications and risk 182
LEARNING OBJECTIVES · INTRODUCTION
7.1 Relevant project cash flows 183
7.2 Taxation and capital investment decisions 184
Example NPV calculation involving taxation 187
7.3 Inflation and capital investment decisions 188
Example NPV calculation involving inflation 190
7.4 Investment appraisal and risk 192
Example Application of sensitivity analysis 193
7.5 Empirical investigations of investment appraisal 199
7.6 Conclusion 201
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
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Contents
8 Portfolio theory and the capital asset pricing model 209
LEARNING OBJECTIVES · INTRODUCTION
8.1 The measurement of risk 210
8.2 The concept of diversification 213
8.3 Investor attitudes to risk 217
8.4 Markowitz’s portfolio theory 219
8.5 Introduction to the capital asset pricing model 222
8.6 Using the CAPM to value shares 223
Vignette 8.1 Sizing up the historical equity risk premium 230
8.7 Empirical tests of the CAPM 231
8.8 Conclusion 234
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
9 The cost of capital and capital structure 241
LEARNING OBJECTIVES · INTRODUCTION
9.1 Calculating the cost of individual sources of finance 242
9.2 Calculating the weighted average cost of capital 246
Example Calculation of the weighted average cost of capital 247
9.3 Average and marginal cost of capital 249
9.4 The CAPM and investment appraisal 250
Example The CAPM in the investment appraisal process 253
9.5 Practical problems with calculating WACC 255
9.6 WACC in the real world 257
9.7 Gearing: its measurement and significance 258
Vignette 9.1 Leeds defends Woodgate sale 260
9.8 The concept of an optimal capital structure 261
9.9 The traditional approach to capital structure 262
9.10 Miller and Modigliani (I): the net income approach 264
Example Arbitrage process using two companies 265
9.11 Miller and Modigliani (II): corporate tax 267

9.12 Market imperfections 267
9.13 Miller and personal taxation 270
9.14 Pecking order theory 271
9.15 Does an optimal capital structure exist? A conclusion 272
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
10 Dividend policy 282
LEARNING OBJECTIVES · INTRODUCTION
10.1 Dividends: operational and practical issues 283
10.2 The effect of dividends on shareholder wealth 286
10.3 Dividend irrelevance 286
10.4 Dividend relevance 288
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Contents
Vignette 10.1 Prudential down 18% on dividend fears 289
Vignette 10.2 M&S buoyed by relief 290
Example Calculation of share price using dividend growth model 291
10.5 Dividend relevance or irrelevance? 293
10.6 Dividend policies 293
Vignette 10.3 FT MONEY: Dubious dividend decisions
that drive me to despair 294
10.7 Alternatives to cash dividends 297
Vignette 10.4 Cadbury defends the bid price 298
Vignette 10.5 Share buybacks rise 92% in US 299
10.8 Empirical evidence on dividend policy 301
10.9 Conclusion 302
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
11 Mergers and takeovers 311
LEARNING OBJECTIVES · INTRODUCTION
11.1 The terminology of mergers and takeovers 312
11.2 Justifications for acquisitions 313
Example Boot-strapping 316
11.3 Trends in takeover activity 318
Vignette 11.1 Water faces up to rising debt levels 320
11.4 Target company valuation 321
Example Takeover (Simpson and Stant) 321
11.5 The financing of acquisitions 328
Vignette 11.2 Morrison bid value drops to £2bn 330
11.6 Strategic and tactical issues 332
Vignette 11.3 The Takeover Panel cracks down on Indigo 335
Vignette 11.4 More EU member states opt for ‘poison pill’ 338
Vignette 11.5 No slanging match as BPB attempts to prove that
its case is mathematically correct 339
11.7 Divestment 340

Vignette 11.6 Just a mention of spin-off can unlock value
for shareholders 342
Vignette 11.7 RSA’s health insurer in £147m MBO 343
11.8 Empirical research on acquisitions 345
11.9 Conclusion 348
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
12 Risk management 359
LEARNING OBJECTIVES · INTRODUCTION
12.1 Interest and exchange rate risk 360
Vignette 12.1 Balance sheets left reeling by the Real 361
Vignette 12.2 Daimler increases hedging against dollar 363
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