FOCU$ ON FINANCIAL MANAGEMENT This page intentionally left blank FOCU$ ON FINANCIAL MANAGEMENT Ivan K Cohen Richmond, the American International University in London imperial College Press Published by Imperial College Press 57 Shelton Street Covent Garden London WC2H 9HE Distributed by World Scientific Publishing Co Pte Ltd Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library FOCUS ON FINANCIAL MANAGEMENT Copyright © 2005 by Imperial College Press All rights reserved This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA In this case permission to photocopy is not required from the publisher ISBN 1-86094-479-5 Printed in Singapore This book is dedicated to those who came before, and to those who follow on Firstly, this book is dedicated to the memory of my late father, Issy (Israel) Cohen z”l, and my beloved mother, Irene Cohen Together they brought me up to be a mensch, and their love and support has enabled me to live a fulfilling life without giving up on fun Secondly, this book is dedicated to my two children, David Jonathan (Yoni) and Maya Isabella, whose energy and vitality keep me going even as they run me ragged! The link between the two groups is my incredible and beautiful wife, Jeanine, whose love continues to be a constant source of strength v This page intentionally left blank Preface This book began its journey to fruition many years ago when I was a Lecturer at the Management School at Imperial College At that time I was approached by Tony Moore and asked to contribute a textbook in Finance to the Imperial College Press Early progress was swift, but soon slowed down due to the interference of “life’s rich tapestry” as appears to often be the case Having started the book as a single man with no major attachments (notwithstanding a passion for Tottenham Hotspur F.C.!), this book enters publication with the author a married man with two young children In writing this book I have been led by my own comments on texts from my student days, as well as by those of my own groups of students on the many contemporary texts in this area One consequence is that I have tried to keep this book relatively short, to the point, and maintain a good flowing narrative Too often, undergraduate textbooks drown the reader in a sea of numerous examples, so that the flow of the material gets lost and it becomes difficult to “see the wood for the trees” I have deliberately opted for a short, focused text, rather than the more encyclopædic variety that inhabits and weighs down too many student bookshelves I have also tried to maintain a sense of high quality, readable English that treats the reader as an equal I hope that I will be regarded as successful in these areas As always, any errors, both of omission and commission, remain my own responsibility vii This page intentionally left blank Acknowledgements This book would never have come to fruition had it not been for the love and support of my wife, the “stupendously sexy” Jeanine A debt of thanks is also due to my young children, David Jonathan (“Yoni”) and Maya Isabella, who must have wondered what it was their father was doing at his G3 Macintosh computer on so many occasions I am also indebted to my stepson, Aviel Levy, for his support and encouragement I would also like to record my thanks to my three brothers, Steven, Alan and Neil, as well as to their respective families, for their support, often in the form of familial banter This project began at the prompting of Tony Moore, then of Imperial College Press, and his help in getting the book started was invaluable Since then I have benefited from the valuable insights of the Imperial College Press team A number of friends, colleagues and students were kind enough to read drafts and offer comments My thanks go out in particular to Raymond Antian, Daniel Cohen (no relation), Catherine Dick, Sharon Foley, Debby McLean, and Mihail Nedev, although the responsibility for any errors remains squarely with me At Imperial College Press, I am indebted to Geetha Nair and Gabriella Frescura for trying to ensure I made some kind of timely progress, as well as to Kim Tan for substantive comments on draft versions of the text More recently I owe a huge debt of thanks to Katie Lydon for her editing prowess Finally, my thanks go out to the Spurs-List, an e-mail forum, which brought me and my wife together, as well as enabling me to be blessed with an abundance of great friends I also would like to thank Tottenham Hotspur F.C., whom I have followed through thick and thin (mostly the latter in recent years!) as both man and boy I hope this book finds as receptive an audience as the teams of Billy Nicholson, Keith Burkinshaw, and whomever is the manager when this book finally hits the shelves ix 128 Focus on Financial Management estimation of the risk involved, although such firms are extraordinarily reluctant to reveal how it has been determined, or even what value it takes! Down the years most studies of British industry’s cost of capital have found it to be much higher than market estimates would suggest Stockbrokers argue that it is in high single digits, and yet companies often prefer a hurdle rate somewhere in the twenty per cent range Given these difficulties, there should be little problem understanding why another DCF (discounted cashflow) technique for appraising capital investment projects is required 6.4.2 Internal Rate of Return (IRR) The Internal Rate of Return (ρ) is that discount rate which gives an investment project a Net Present Value (NPV) of zero Thus: T ∑ CF t − I0 t t=1 (1 + ρ ) NPV = = T Alternatively ∑ CF t = I0 t t=1 (1 + ρ ) The Internal Rate of Return may be found by trial-and-error, which is old-fashioned but effective, or with the aid of a financial calculator More common nowadays is the use of spreadsheet functions, such as those found in (e.g.) Microsoft® Excel™ In each case, a guess is made for a starting value for the IRR; the NPV for this guess is then calculated • If the NPV turns out to be positive, then the next guess for the IRR must be higher (due to the negative relationship between the discount rate and NPV) • If the NPV turns out to be negative, then a lower value guess of IRR must be chosen Investment Appraisal: Capital Budgeting 129 This process of plugging in guesses of the value of IRR continues until IRR is found such that the NPV is equal to zero.3 Once the IRR has been determined it can then be measured against a reference rate, usually the cost of acquiring funds (r): ρ>r the project is acceptable ρ