Financial management and real options

457 Pages·2003·2.348 MB·English

by  Jack Broyles

Financial
Management and
Real Options
Jack Broyles
Copyright#2003JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,
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Contents
Preface xi
Part 1 Introduction to Financial Management 1
1 Financial Management and Corporate Governance 3
1-1 WhatFinancialManagementisReallyAbout 3
1-2 HowFinanceIsOrganizedinCorporations 6
1-3 TheChiefFinancialOfficer 8
1-4 TheChiefAccountant 8
1-5 TheTreasurer 9
1-6 CorporateFinancialObjectives 11
1-7 CorporateGovernance 14
1-8 Conclusions 15
FurtherReading 15
QuestionsandProblems 15
2 Fundamental Methods of Financial Analysis 17
2-1 Whatisarateofreturn? 18
2-2 WhatisRisk? 19
2-3 HowtoRelateRequiredRatesofReturntoRisk 22
2-4 DiscountedCashFlowandNetValueforShareholders 24
2-5 PrecisionDiscounting 28
2-6 TheInternalRateofReturn 30
2-7 ThePresentValueofaPerpetuity 32
2-8 ThePresentValueofanAnnuity 33
2-9 TheLoanBalanceMethod 36
2-10 TheValueofGrowth 37
2-11 WhyFlexibilityandChoiceHaveValue 37
2-12 Conclusions 39
QuestionsandProblems 39
iv
CONTENTS
3 An Introduction to Corporate Debt and Equity 42
3-1 HowMuchShouldanInvestorpayforaCorporateBond? 43
3-2 HowMuchShouldanInvestorPayforSharesinaCompany’s
Equity? 46
3-3 HowLimitedLiabilityAffectstheRelativeValuesofEquityand
Debt 49
3-4 ExecutiveStockOptions 52
3-5 EquityWarrants 53
3-6 OtherCorporateSecurities 54
3-7 TradedEquityOptions 55
3-8 Conclusions 57
FurtherReading 57
QuestionsandProblems 57
Appendix3.1 UsingtheBlackandScholesOptionPricingFormula 59
4 Shareholder Value in Efficient Markets 61
4-1 ConditionsConducivetoCapitalMarketEfficiency 62
4-2 Weak-formTestsofMarketEfficiency 64
4-3 Semistrong-formTestsofMarketEfficiency 66
4-4 Strong-formTestsofMarketEfficiency 68
4-5 ApparentExceptionstoMarketEfficiency 71
4-6 Conclusions 73
FurtherReading 73
QuestionsandProblems 73
Part 2 Valuation of Investment and Real Options 75
5 An Introduction to the Appraisal of Capital Projects 77
5-1 CapitalBudgeting 78
5-2 CompetitiveAdvantageandValueCreation 78
5-3 ProjectAppraisal 79
5-4 IncrementalCashFlowandIncrementalValue 80
5-5 NetPresentValue 83
5-6 TheRateofReturnonaProject 83
5-7 ProjectLiquidity 85
5-8 SomeRelatedIssues 87
5-9 AboutTaxes 89
5-10 MeasuringProjectRiskandDeterminingtheDiscountRate 89
5-11 RealOptions 91
5-12 Conclusions 91
FurtherReading 93
QuestionsandProblems 93
v
CONTENTS
6 Pitfalls in Project Appraisal 96
6-1 SpecifyingaProject’sIncrementalCashFlowRequiresCare 96
6-2 TheInternalRateofReturnIsBiased 98
6-3 ThePaybackPeriodIsOftenAmbiguous 103
6-4 DiscountRatesAreFrequentlyWrong 104
6-5 RisingRatesofInflationAreDangerous 106
6-6 ThePreciseTimingofCashFlowsIsImportant 109
6-7 ForecastingIsOftenUntruthful 110
6-8 RiskAddsValuetoRealOptions 110
6-9 RealOptionsAffecttheNPVRule 111
6-10 Conclusions 112
FurtherReading 113
QuestionsandProblems 114
7 Further Project Appraisal Methods 116
7-1 AdjustedPresentValueMethod 116
7-2 MultiperiodCapitalRationing:TheProfitabilityIndexAnnuity 120
7-3 MultiperiodCapitalRationing:MathematicalProgramming 123
7-4 MeasuringProjectYield 127
7-5 Conclusions 131
FurtherReading 132
QuestionsandProblems 132
8 Appraising Projects with Real Options 134
8-1 RealOptionsinCapitalProjects 135
8-2 TheImpactofUncertaintyonProjectProfitability 137
8-3 HowUncertaintyCreatesRealOptionValue 138
8-4 EstimatingthePIoftheExpectedPayoffonaRealOption 140
8-5 Risk-neutralValuationofRealOptions 141
8-6 RefiningtheValuation 144
8-7 Applications 147
8-8 Conclusions 149
FurtherReading 150
QuestionsandProblems 150
9 Valuing Interrelated Real Options 155
9-1 TheProjectFrame 155
9-2 TheOne-stepBinomialTree:TwoBranches 157
9-3 MultistepBinomialTrees:MoreBranches 162
9-4 IncorporatingtheValuesofRealOptions 163
9-5 ObtainingtheNetPresentValueoftheProject 166
vi
CONTENTS
9-6 RealOptionsSensitivityAnalysis 166
9-7 Conclusions 171
FurtherReading 172
QuestionsandProblems 172
10 Valuation of Companies with Real Options 174
10-1 AreFinancialRatiosSufficienttoValueaCompany? 174
10-2 TheInvestmentOpportunitiesApproach 176
10-3 FormulationoftheInvestmentOpportunitiesApproach 177
10-4 InputstotheInvestmentOpportunitiesApproach 184
10-5 InvestmentOpportunitiesasExpectedPay-offsonRealOptions 188
10-6 Conclusions 190
FurtherReading 190
QuestionsandProblems 190
11 Mergers and Acquisitions 194
11-1 WhatareMergersandAcquisitions? 195
11-2 TypesofMerger 195
11-3 MergerWaves 196
11-4 MotivationsforMergersandAcquisitions 197
11-5 HowMuchtoPayforanAcquisition 199
11-6 Synergy 203
11-7 OtherMotivesforMergersandAcquisitions 207
11-8 FinancingMergersandAcquisitions 208
11-9 TheBiddingProcess 209
11-10 DefendingAgainstaBid 210
11-11 WhoGainsfromMergersandAcquisitions? 212
11-12 Conclusions 213
FurtherReading 214
QuestionsandProblems 214
Part 3 Financial Structure 219
12 Portfolio Theory and Asset Pricing 221
12-1 ReturnstoEquityInvestors 222
12-2 RisktoEquityInvestors 223
12-3 RiskReductionthroughPortfolioDiversification 226
12-4 TheTwo-SecurityPortfolio 228
12-5 PortfoliosofMorethanTwoSecurities 231
12-6 EfficientPortfolioDiversification 233
12-7 TheOptimumPortfolioofRiskySecurities 234
vii
CONTENTS
12-8 TheCapitalAssetPricingModel(CAPM) 236
12-9 UsingtheCapitalAssetPricingModel 238
12-10 LimitationsoftheCapitalAssetPricingModel 239
12-11 ArbitragePricingTheory(APT) 240
12-12 Summary 241
FurtherReading 242
QuestionsandProblems 242
Appendix12.1 CalculationoftheStandardDeviation 244
Appendix12.2 CalculationoftheCorrelationCoefficient 245
13 Calculating the Cost of Capital 246
13-1 AdjustingtheWeightedAverageCostofCapitalforRisk 247
13-2 EstimatingtheCompany’sWeightedAverageCostofCapital 248
13-3 ExtractionoftheCompany’sRiskPremiumfromItsWACC 252
13-4 AdjustingtheCompany’sRiskPremiumforProjectRisk 252
13-5 AdjustingtheWACCfortheProject’sRiskPremium 255
13-6 TheCostsofCapitalforaRiskClass 255
13-7 Conclusions 258
FurtherReading 258
QuestionsandProblems 258
Appendix13.1 After-taxInterestRatesforTemporarilyNon-taxpaying
Companies 260
Appendix13.2 LinearGrowthandtheCostofEquity 261
Appendix13.3 TheMethodofSimilars 262
14 Long-term Financing 264
14-1 FinancialPolicy 265
14-2 PrimaryandSecondaryFinancialMarkets 266
14-3 CorporateSecurities 267
14-4 GovernmentDebt 268
14-5 CorporateDebt 272
14-6 CorporateEquity 275
14-7 HowSecuritiesareIssuedinthePrimaryMarket 277
14-8 TheRightsIssueProcedure 279
14-9 RightsIssuesandMarketPrices 279
14-10 RightsIssueSignalingEffects 281
14-11 NewIssuesforUnquotedCompanies 281
14-12 Conclusions 282
FurtherReading 282
QuestionsandProblems 283
Appendix14.1 Moody’sCorporateBondRatings 284
viii
CONTENTS
15 Dividend Policy 286
15-1 DividendsandEarnings 286
15-2 DividendsasSignals 289
15-3 IsDividendPolicyIrrelevant? 289
15-4 IsDividendPolicyAffectedbyPersonalTaxes? 292
15-5 DividendPolicyandShareholderTaxClienteles 294
15-6 DividendPolicyandPortfolioDiversification 295
15-7 AlternativestoPayingCashDividends 296
15-8 MacroeconomicConsiderations 297
15-9 Conclusions 298
FurtherReading 299
QuestionsandProblems 299
16 Capital Structure 303
16-1 WhatisCapitalStructureandWhyDoesitMatter? 303
16-2 HowCapitalStructureAffectsFinancialRisk 305
16-3 TheWeightedAverageCostofCapital 308
16-4 ContrastingViewsontheRelevanceofCapitalStructure 310
16-5 ArbitrageandtheNetOperatingIncomeView 313
16-6 TaxesinaClassicalTaxSystem 316
16-7 TaxEffectsinModiglianiandMiller’sEquilibrium 318
16-8 TaxEffectsinMiller’sAfter-taxEquilibrium 319
16-9 TheExistenceofOptimumCapitalStructures 322
16-10 TheRelevanceofFlotationCosts 324
16-11 ACombinedApproach 325
16-12 Conclusions 327
FurtherReading 328
QuestionsandProblems 328
17 Lease Finance 331
17-1 LeasingandOwnership 332
17-2 WhyCompaniesLeaseAssets 334
17-3 HowLeasingCanAffecttheCapitalInvestmentDecision 335
17-4 HowtoValueaFinancialLease 335
17-5 HowTemporaryNon-taxpayingAffectstheLeasingDecision 338
17-6 TheAfter-taxDiscountRate 339
17-7 TheLoanBalanceMethod 339
17-8 TheInternalRateofReturnApproach 341
17-9 ResidualValues 342
17-10 InteractionsbetweenLeasingandInvestmentDecisions 344
17-11 LeaseRatesandCompetitionintheLeasingMarket 344
ix
CONTENTS
17-12 Conclusions 345
FurtherReading 345
QuestionsandProblems 345
Part 4 Solvency management 347
18 Financial Planning and Solvency 349
18-1 ImportanceofFinancialPlanningandControl 350
18-2 TheProformaCashbudgetandShort-termBorrowing 352
18-3 TheFundsFlowStatementandLongerTermFinancing 355
18-4 FinancialModeling 357
18-5 FinancialForecasting 359
18-6 StructuringUncertainty 360
18-7 ScenariosoftheFuture 361
18-8 FinancialPlanningProcedure 364
18-9 Conclusions 365
FurtherReading 365
QuestionsandProblems 366
19 Managing Debtor Risk 367
19-1 CreditTerms 367
19-2 TheTradeCreditDecision 369
19-3 TradeCreditasaLendingDecision 370
19-4 TradeCreditasanInvestmentDecision 372
19-5 TheControlofTradeCredit 375
19-6 Conclusions 376
FurtherReading 377
QuestionsandProblems 377
20 Managing Inventory Risk 379
20-1 PlanningandMonitoringInventoryLevels 380
20-2 DesigningtheInventoryControlSystem 383
20-3 ElementsofanInventoryControlSystem 384
20-4 OperatingtheInventoryControlSystem 388
20-5 Conclusions 389
FurtherReading 389
QuestionsandProblems 389
Appendix20.1 EconomicOrderQuantities 390