What’s new? • Chapter vignettes are refreshed and the accompanying questions are updated with the aim of deepening student’s knowledge of key contemporary issues • Up to date with the latest changes in regulations and taxation, such as the UK tax treatment of dividends Join over 10 million students benefiting from Pearson MyLabs This title can be supported by MyLab Finance, an online homework and tutorial system designed to test and build your understanding MyLab Finance provides a personalised approach, with instant feedback and numerous additional resources to support your learning It includes: • • • • • A personalised study plan Usable either following chapter-by-chapter structure or by learning objective New questions and case studies to help you apply what you’ve learned Worked solutions showing you how to solve difficult problems Limitless opportunities to practise Use the power of MyLab Finance to accelerate your learning You need both an access card and a course ID to access MyLab Finance: Is your lecturer using MyLab Finance? Ask your lecturer for your course ID Has an access card been included with the book? Check the inside back cover of the book If you have a course ID but no access card, go to www.pearson.com/mylab/finance to buy access Front cover image © Denzil Watson CVR_WATSON_08_44310.indd Eighth edition DENZIL WATSON & ANTONY HEAD CORPORATE FINANCE PRINCIPLES AND PRACTICE Eighth edition WATSON & HEAD Denzil Watson is a Principal Lecturer and Antony Head is an Associate Lecturer at the Sheffield Business School, Sheffield Hallam University They have extensive experience of teaching corporate finance, managerial finance and strategic financial management over many years and in a wide range of courses at undergraduate, postgraduate and professional level CORPORATE FINANCE In this new and fully updated eighth edition, the core concepts and topics of corporate finance are introduced in an approachable, user-friendly style Key principles and mathematical techniques needed for a career in business are clearly explained step by step and are put into practice through numerous examples and vignettes which take a closer look at real-world and well-known companies www.pearson-books.com 15/01/2019 13:08 CORPORATE FINANCE F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 At Pearson, we have a simple mission: to help people make more of their lives through learning We combine innovative learning technology with trusted content and educational expertise to provide engaging and effective learning experiences that serve people wherever and whenever they are learning From classroom to boardroom, our curriculum materials, digital learning tools and testing programmes help to educate millions of people worldwide – more than any other private enterprise Every day our work helps learning flourish, and wherever learning flourishes, so people To learn more, please visit us at www.pearson.com/uk F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 CORPORATE FINANCE PRINCIPLES AND PRACTICE Eighth edition Denzil Watson and Antony Head Sheffield Hallam University Harlow, England • London • New York • Boston • San Francisco • Toronto • Sydney • Dubai • Singapore • Hong Kong Tokyo • Seoul • Taipei • New Delhi • Cape Town • São Paulo • Mexico City • Madrid • Amsterdam • Munich • Paris • Milan F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 PEARSON EDUCATION LIMITED KAO Two KAO Park Harlow CM17 9SR United Kingdom Tel: +44 (0)1279 623623 First published under the Financial Times Pitman Publishing Imprint 1998 (print) Second edition published under the Financial Times Prentice Hall Imprint 2001 (print) Third edition published 2004 (print) Fourth edition published 2007 (print) Fifth edition published 2010 (print) Sixth edition published 2013 (print and electronic) Seventh edition published 2016 (print and electronic) Eighth edition published 2019 (print and electronic) © Pearson Education Limited 2001, 2010 (print) © Pearson Education Limited 2013, 2016, 2019 (print and electronic) The rights of 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 The print publication is protected by copyright Prior to any prohibited reproduction, storage in a retrieval system, distribution or transmission in any form or by any means, electronic, mechanical, recording or otherwise, permission should be obtained from the publisher or, where applicable, a licence permitting restricted copying in the United Kingdom should be obtained from the Copyright Licensing Agency Ltd, Barnard’s Inn, 86 Fetter Lane, London EC4A 1EN The ePublication is protected by copyright and must not be copied, reproduced, transferred, distributed, leased, licensed or publicly performed or used in any way except as specifically permitted in writing by the publishers, as allowed under the terms and conditions under which it was purchased, or as strictly permitted by applicable copyright law Any unauthorised distribution or use of this text may be a direct infringement of the authors’ and the publisher’s rights and those responsible may be liable in law accordingly 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 Contains public sector information licensed under the Open Government Licence (OGL) v3.0 http://www nationalarchives.gov.uk/doc/open-government-licence/version/3/ Contains Parliamentary information licensed under the Open Parliament Licence (OPL) v3.0 http://www parliament.uk/site-information/copyright/open-parliament-licence/ Pearson Education is not responsible for the content of third-party internet sites The Financial Times With a worldwide network of highly respected journalists, The Financial Times provides global business news, insightful opinion and expert analysis of business, finance and politics With over 500 journalists reporting from 50 countries worldwide, our in-depth coverage of international news is objectively reported and analysed from an independent, global perspective To find out more, visit www.ft.com/pearsonoffer ISBN: 978-1-292-24431-0 (print) 978-1-292-24433-4 (PDF) 978-1-292-24434-1 (ePub) British Library Cataloguing-in-Publication Data A catalogue record for the print edition is available from the British Library Library of Congress Cataloging-in-Publication Data Names: Watson, Denzil, author | Head, Antony, 1953- author Title: Corporate finance : principles and practice / Denzil Watson and Antony Head, Sheffield Hallam University Description: Eighth edition | Harlow, England ; New York : Pearson, 2019 Identifiers: LCCN 2018060711| ISBN 9781292244310 (print) | ISBN 9781292244334 (pdf) | ISBN 9781292244341 (epub) Subjects: LCSH: Corporations—Finance Classification: LCC HG4026 W373 2019 | DDC 658.15—dc23 LC record available at https://lccn.loc.gov/2018060711 10 23 22 21 20 19 Front cover image © Denzil Watson Print edition typeset in 9.25/13.5pt Stone Humanist ITC Pro by Pearson CSC Printed in Slovakia by Neografia NOTE THAT ANY PAGE CROSS REFERENCES REFER TO THE PRINT EDITION F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 Antony Head is an Associate Lecturer in the Sheffield Business School at Sheffield Hallam University, having formerly been a Principal Lecturer in Financial Management there and Leader of the Financial Accounting and Management Accounting Subject Group Tony joined Hallam after various jobs, which included spells as a chemical engineer and health-food shop proprietor His higher education began in Sheffield, where he took an honours degree in Chemical Engineering and Fuel Technology at Sheffield University in the early 1970s Since then Tony has completed an MBA and a PGCFHE and can be found teaching financial management, corporate finance and risk management as required on undergraduate, postgraduate and professional modules at Sheffield Hallam University Tony, like Denzil, has many interests outside of academia As well as being a dedicated Derby County fan he is studying for a classics degree with the Open University His musical tastes are wide and varied, including Bob Dylan, Miles Davis, King Crimson, David Sylvian, Gustav Mahler and Philip Glass Tony lives with his wife Sandra and has a daughter Rosemary, a son Aidan, a step-daughter Louise, step-sons Michael and Robert, and six grandchildren: Joshua, Isaac, Elizabeth, Amelia, Magnus and Arlo, with a seventh grandchild on the way Photo: Denzil Watson Denzil Watson is a Principal Lecturer in Finance in the Sheffield Business School at Sheffield Hallam University (http://www.shu.ac.uk) Denzil has been teaching finance since he joined Hallam in 1991, having completed his BA(Hons) in Economics and MA(Hons) in Money, Banking and Finance at Sheffield University in the 1980s He has taught financial management, corporate finance, risk management, microeconomics and financial markets for 28 years over a range of undergraduate, postgraduate and distance learning modules Finance is by no means Denzil’s only passion He is a committed traveller, having now visited over 50 countries including ones as diverse as Peru, Syria, Uzbekistan, Vietnam, Laos and travelled along the Chinese Silk Road Travel photography is also high up on his list as evidenced by the covers of this book and its previous editions He is a keen Urbexer and, along with his co-author, a long-suffering Derby County fan His other great love is music He can be found fronting Sheffield post-New Wave indie group RepoMen (http://repomen.bandcamp.com), alt-rockers Batman’s Treaty or listening to the likes of Joy Division, The Stranglers, The Perfect Disaster, Spear of Destiny, Dubioza Kolektiv, That Petrol Emotion, Sleaford Mods, British Sea Power, Dead Kennedys, The Clash and Cabbage His inspirations include his mother Doreen, his sadly departed father Hugh, Kevin Hector, Ian Curtis, Michael Palin, Joe Strummer and John Peel Denzil lives with his wife Dora and their two children, Leonardo and Angelina Photo: Andy Brown ABOUT THE AUTHORS v F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 www.freebookslides.com F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 CONTENTS Preface Acknowledgements The finance function Learning objectives Introduction xiii xv 1 1.1 Two key concepts in corporate finance 1.2 The role of the financial manager 1.3 Corporate objectives 1.4 How is shareholder wealth maximised? 1.5 Agency theory 1.6 Corporate governance 1.7 Conclusion 11 13 20 26 Key points Self-test questions Questions for review Questions for discussion References Recommended reading 29 31 32 33 33 34 Capital markets, market efficiency and ratio analysis 35 Learning objectives Introduction 35 36 2.1 Sources of business finance 2.2 Capital markets 2.3 Capital market efficiency 2.4 Assessing financial performance 2.5 Conclusion 36 39 41 49 68 Key points Self-test questions Questions for review Questions for discussion References Recommended reading 68 70 71 72 74 76 vii F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 www.freebookslides.com CONTENTS Short-term finance and working capital management 77 Learning objectives 77 Introduction78 3.1 The objectives of working capital management 3.2 Working capital policies 3.3 Working capital and the cash conversion cycle 3.4 Overtrading 3.5 Managing inventory 3.6 Managing cash 3.7 Managing trade receivables 3.8 Conclusion 78 78 82 85 86 91 94 100 Key points 100 Self-test questions 101 Questions for review 102 Questions for discussion 103 References105 Recommended reading 105 Long-term finance: equity finance 106 Learning objectives 106 Introduction107 4.1 Equity finance 4.2 The Stock Exchange 4.3 Rights issues 4.4 Scrip issues, share splits, scrip dividends and share repurchases 4.5 Preference shares 4.6 Conclusion 107 109 114 120 125 128 Key points 128 Self-test questions 130 Questions for review 131 Questions for discussion 132 References133 Recommended reading 133 5 Long-term finance: debt finance, hybrid finance and leasing 135 Learning objectives 135 Introduction136 5.1 5.2 5.3 5.4 Bonds, loan notes, loan stock and debentures Bank and institutional debt International debt finance Convertible bonds 136 143 145 145 viii F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 www.freebookslides.com CONTENTS 5.5 Warrants 5.6 Valuing fixed interest bonds 5.7 Valuing convertible bonds 5.8 Leasing 5.9 Evaluating the financial effects of financing choices 5.10 Conclusion 149 150 152 154 159 161 Key points 161 Self-test questions 163 Questions for review 164 Questions for discussion 165 References166 Recommended reading 166 An overview of investment appraisal methods 168 Learning objectives 168 Introduction169 6.1 The payback method 6.2 The return on capital employed method 6.3 The net present value method 6.4 The internal rate of return method 6.5 Comparing the NPV and IRR methods 6.6 The profitability index and capital rationing 6.7 The discounted payback method 6.8 Conclusion 169 171 174 177 181 185 192 192 Key points 192 Self-test questions 194 Questions for review 195 Questions for discussion 196 References198 Recommended reading 198 Investment appraisal: applications and risk 199 Learning objectives 199 Introduction200 7.1 Relevant project cash flows 7.2 Taxation and capital investment decisions 7.3 Inflation and capital investment decisions 7.4 Investment appraisal and risk 7.5 Appraisal of foreign direct investment 7.6 Empirical investigations of investment appraisal 7.7 Conclusion 200 202 207 210 217 223 226 Key points Self-test questions 226 227 ix F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 www.freebookslides.com INDEX efficient frontier portfolios 248–9, 250, 251, 473 Elliott Advisors 385, 386 employee share ownership plans (ESOP) 473 employees mergers and takeovers and 394 share option 16 Endless 138 enhanced scrip dividends 336, 473 Enron 20, 21, 25, 437 Enterprise Act of 2002 375 Enterprise Finance Guarantee Scheme 143 envelope curves 473 EOQ (economic order quantity) 88–9, 472 EPS see earnings per share EQR 138 Equistone 388 equity cross-holdings 381 private 387–8 requirements for 297–9 restructuring of 380 equity betas 254–7, 263, 282–3, 284, 285 equity finance 37, 107–8 agency problem 15 foreign direct investment 294 management buyouts 386–9 new issues market 109 rights of ordinary shareholders 107–8 pecking order theory 308–10 risk and return 108 vs debt finance 159–61 equity risk premiums 260, 261, 275, 284, 293, 473 equity sweetener 149, 473 Euler Hermes 442 Eurex Clearing 427, 428 Eurobonds 145, 473 Eurocurrency 473 markets 417 Euronext LIFFE 419 Euronotes 473 European options 422 European Union Merger Regulation 375 poison pills 380 Eurotunnel plc331, 341 EVA® see economic value added ex dividend 115 ex dividend prices 274, 275, 321–2, 343 exchange rate risks 7, 406–11, 473 economic risks 414, 472 external 416–18 management (hedging) 439–41 forward contracts 416–17 futures contracts 416, 418–21 internal 414–5 invoicing in domestic currencies 416 lagging 416 leading 416 matching 415 money market hedges 416, 417 netting 415–16 options 421, 423, 424, 426 pros and cons 435–9 smoothing 415 strategies 432–5 swaps 426, 431–2 swaptions 432 meaning 429–30 takeovers 359 transaction risks 413, 415 translation risks 413–14 exchange rates appreciation 413 buy rates 412 caps 422 collars 422, 424 depreciation 412 floors 422 forward rates 412–13 price of traded options and 425–6 spread 412 sterling–dollar408 volatility 426 executive share option schemes 16 exercise price 149, 473 expectations, shareholders 321 expected net present value calculation of 215–16 probability analysis 214–15 expropriation of assets 295, 441 external finance 37–9, 309–10 EY 138 face value 50 see also nominal value factoring 98–100, 473 Farfetch 110 FEC (forward exchange contracts) 416 finance director finance lease 155 Finance Service Compensation Scheme (FSCS_ 144 487 Z04 Corporate Finance 44310.indd 487 23/01/2019 20:15 www.freebookslides.com INDEX finance sources 36–9 financial accounting Financial Conduct Authority (FCA) 81, 127, 407 financial credibility 297 financial engineering 473 financial evaluations 159–61 financial gearing 473 financial institutions mergers and takeovers roles 394 see also banks; building societies financial justifications for acquisitions 356–8 financial managers role of 5–7 financial performance benchmarks 52–4 company managers 49–50 financial statements 50–2 information sources 50 investors 49 shareholders 49 financial position statements gearing ratios 295 retained earnings 38–9 financial ratios 63–5 Financial Reporting Council (FRC) UK Stewardship Code 18–19 financial risks 473 betas 254 cost of equity and 302 equity betas 283, 284 gearing levels and 299–300, 302 interest rates and 411 meaning 283 premiums 294, 300 Financial Services and Markets Act 109, 112 Financial Services Authority (FSA) 109 financial statements 36, 50–2 financial synergy 356 financing choices 159–61 financing decisions 7, 321 agency problem 14–15 examples of 12–13 financing policies 443 financing working capital 82 Fitch Group 140 fixed assets see non-current assets fixed charge security 137, 473 fixed percentage payout ratio 331 fixed to fixed swaps 431 fixed to floating swaps 431 fixed-interest bonds 150–2 floating charge security 137, 473 floating interest rate 140 floating rate 126 floors 422, 473 fluctuating current assets 82, 473 foreign bond 473 foreign currencies debt finance denominated in 290 risks 295 swaps 431–2 foreign direct investment (FDI) appraisal 293–4 cost of capital 293–5 distinctive features 217 empirical investigations 225–6 evaluation 220–2 financial evaluation 218 financing decisions 294 investment appraisal 217–22 local level evaluation 218–19 parent company level evaluation 219–20 political risks 295 taxation and 220 forward contracts 416–17 forward exchange contracts (FEC) 416 forward rate agreements (FRA) 416, 473 FRC see Financial Reporting Council free cash flow 473 free riders 15, 473 FSA (Financial Services Authority) 109 fundamental analysis 43, 47, 473 Funding Circle 110, 111 future value of money futures contracts 417, 473 basis risks 420, 421 exchange rate risk hedging 419–21 initial margins 418, 421 interest rate risk hedging 419–20, 420–1 meaning 418 sterling-denominated 420 swaps 427 variation margins 418, 421 GAAP 53–4, 440 Galliford Try 40 GAM 128 gap exposure 412, 473 gearing bankruptcy and 306–7, 310 cost of equity curve and 301 divestments and 383 488 Z04 Corporate Finance 44310.indd 488 23/01/2019 20:15 www.freebookslides.com INDEX dividend policies and 323 financial risk and 300, 301, 302 foreign direct investment 294 measurement 295–9 pecking order theory and 308–10 profits and 309 ratios 295 required rate of return 299–300 restructuring of equity 380 share repurchases 338 short-termism and 297 significance 295–9 takeovers 359, 371 tax exhaustion and 307–8 weighted average cost of capital and 302 gearing effect of warrants 150 gearing ratios 55, 59–61, 137 Gécamines 124 General Atlantic 111 General Electric 45, 53 general inflation 207–8 geometric mean 473 gilt-edged government securities 94, 473 GlaxoSmithKline 11 Glencore 124–5 global dealmaking 361–2 global risk premiums 293 goal congruence 15, 473 golden parachutes 381–2, 473 Goldman Sachs 394 Google 110, 361 grand tour 442 Greenbury Report 21 gross profit margin 56 growth acquisition as means of 356 dividends see dividends GTCR 391 guarantees, subsidiaries by holding companies 294 H&M Hennes & Mauritz 90 Hangzhou Union Bank 188 Hanson plc 383 hard capital rationing 187 HBOS 81 hedge efficiency 420 hedge fund 474 hedging 474 diversification by shareholders superior to438–9 methods 435 using money markets and eurocurrency markets 417–19 policies 434, 435 Hewlett-Packard 334 holding companies, guarantees of subsidiaries by 294 horizontal merger 474 horizontal takeovers 353, 355, 359 Hotel Chocolat 40–1 House of Fraser 138 HSBC 138, 144, 298 hurdle rates 285, 293 hybrid finance 474 IAS 39 Financial instruments: recognition and measurement 437 IASB (International Accounting Standards Board) 437 ICAPM (international capital asset pricing model) 293 ICE Futures Europe 419 Iceland plc 355 IG Group 334 income gearing 474 income tax 328, 336, 343 income-based target company valuations 363, 366–70 incremental cash flows 200 incremental marginal cost of capital 282 incremental working capital 202 Independent Gas Transporters 291 index tracker funds 250, 251–2 Index Ventures 111 indifference curves 474 Indivior Reckitt 385 indivisible investment projects 191 inflation capital investment decisions 207–10 general 207–8 investment appraisal 208 nominal cost of capital 207 NPV calculation 208–10 real cost of capital 207 specific 207–8 time value of money and working capital 208 informational efficiency 41 initial margins, futures contracts 418, 421 initial public offering (IPO) 109, 474 insider dealing 474 inspection visits, overseas 442 institutional debt 143–4 489 Z04 Corporate Finance 44310.indd 489 23/01/2019 20:15 www.freebookslides.com INDEX institutional investors 17–20, 474 dividend preferences 331, 332 tax positions 371 insurance against bad debts 97 political risk 443 interbank market 474 intercompany trade receipts 219 interest cover 474 payments bank loans 278 default on, and bankruptcy risk 296–7 distributable profits and 300 dividend policies and 323 relevant cash flow 204–5 rates see interest rate risks; interest rates interest coverage ratio 60–1 interest gearing ratio 60–1 interest rate risks 406–11, 474 basis risks 412 floating interest rates 412 gap exposure 412 internal management of 414–15 management (hedging) 406–11 forward contracts 416–17 futures contract 418–21 money market hedges 417–18 options 421 pros and cons 435–9 strategies 432–5 swaps 427, 432 swaptions 432 interest rates after-tax 157 bank borrowings 278 before-tax 157 caps 422 collars 422, 424 Eurobonds 145 fixed 300, 411, 415 floating 140, 296, 300, 411 floors 422 price of traded options and 425–6 swaps (IRS) 289, 427–31, 432 volatility 406–11, 426 internal finance 37–9, 309–10 internal funds see retained earnings internal market 189 internal rate of return (IRR) 177–81 calculation 178–81 cost of capital 274, 276 discount rate changes 184 foreign direct investment 294 non-conventional cash flows and 183 NPV method compared 181–5 reinvestment assumptions 184 internal risk management 414–16 of exchange rate risk 415–16 of interest rate risk 414–15 International Accounting Standards (IAS) IAS 39 Financial instruments: recognition and measurement 437 International Accounting Standards Board (IASB) 437 international bonds 474 international capital asset pricing model (ICAPM) 293 international debt finance 145 international financing decision 294 international investors 20 International Securities Exchange (ISE) 424 intrinsic values traded options 426 warrants 149–50 inventories buffer 88–9 economic order quantity 88–9 just-in-time policies 89–90 lead times 88–9 management 86–90 inventory conversion period 83 inventory days 57–8 inventory turnover 57–8 Invesco 128 Investec Wealth & Investment 341 investment appraisal adjusted present value (APV) method 293 average cost of capital and 281–2 capital asset pricing model (CAPM) and 282–8 conservative forecasts 213 discounted payback method 171 empirical investigations 223–6 expected net present value 214–16 foreign direct investment see foreign direct investment inflation 208, 224 marginal cost of capital and 282 net present value 174–7 payback method 169–71, 213 probability analysis 214–15 relevant cash flows 200–2 risk-adjusted discount rates 214 490 Z04 Corporate Finance 44310.indd 490 23/01/2019 20:15 www.freebookslides.com INDEX risk and 210–17 simulation models 217 taxation and 202–7 see also internal rate of return; net present value; payback method; return on capital employed investment decisions 5, investment-grade bonds 140 investment projects conventional 169 discount rate changes 184 divisible 190–1 indivisible 191 mutually exclusive 181–3 non-deferrable 191 investment trusts 251–2 investor ratios 55, 61–3 investors attitudes to risk 245–7 relations with 380 invoice discounting 99 invoicing in domestic currency 416 IPO (initial public offering) 109, 474 IRR see internal rate of return irredeemable bonds 139, 150–1, 275–6, 474 ISE (International Securities Exchange) 424 iZettle 110 Jones Bootmaker 138 JP Morgan 298 JP Morgan Chase 395 junk bonds 141, 372, 474 just-in-time (JIT) production method 85, 474 Kerviel, Jérôme 437 KL 379 Kohlberg Kravis Roberts (KKR) 372, 390, 391 KPN 379 lagging 416, 474 late payments 96, 97 Lattice Group 353 lazy portfolios 251 LBO (leveraged buyouts) 388 LCH 427–8 lead time 474 leading 416 leasing average cost of capital 289 borrowing vs 157–8 definition 154–5 finance 155 non-tax reasons for 156 operating 155 reporting 155 as source of finance 156–8 tax reasons for 155 Leeson, Nick 437 legal controls, mergers and takeovers 375–6 Lehman Brothers 297 lessee 154, 474 lessor 154, 474 leveraged buyouts (LBO) 388 leveraged takeovers 372, 474 LIBOR (London Interbank Offered Rate) 94, 126, 140, 407–8, 412, 415, 419, 420, 429–30, 430–1, 431–2, 474 LIFFE (London International Financial Futures Exchange) 418–19 liquidation value 365–6 liquidity 78, 323 preference 214 ratios 55, 59 Lloyd’s of London 442 Lloyds Banking Group 81, 144, 201 loan note 136, 474 loan stock 136 loans bank 278 see also debt finance London Interbank Offered Rate (LIBOR) 94, 126, 140, 407–8, 412, 415, 419, 420, 429–30, 430–1, 431–2, 474 London International Financial Futures Exchange (LIFFE) 418–19 London Stock Exchange (LSE) 21, 40, 339 London Trade Options Market (LTOM) 418, 424 long positions 420, 474 Long Term Capital Management (LTCM) 437 long-term debt finance 136 long-term finance 274–8, 294 long-term incentive plans (LTIPs) 16–17 LSE (London Stock Exchange) 21, 40, 339 LTOM (London Trade Options Market) 418, 424 M&G 128 macro-assessments of political risks 441–2 Mainstream Renewable Power 388 management accounting management buy-ins (MBI) 386, 474 management buyouts (MBO) 386–9, 474 managerial motives for acquisitions 358 491 Z04 Corporate Finance 44310.indd 491 23/01/2019 20:15 www.freebookslides.com INDEX managers incentives 16–17 remuneration 16 retrenchment devices 380 takeovers and benefits 395–6 elimination of inefficient managers 355 motives 358 wealth maximisation 358 Manchester United football club 395 mandatory offer 474 Mannesmann 359 Maplin 138 marginal cost of capital 281–2 marginal trading 365, 474 market betas 254 market capitalisation 12, 363, 474 market for corporal control 114 market imperfections 305–7 market portfolio 248, 250, 265, 474 market power 356 market prices 321–3 market share 356 market values 107 of convertible bond 153–4, 289 gearing ratio calculation and 295 weighted average cost of capital 290 marking to market 418 Markowitz’s portfolio theory 239, 245, 247–50, 265 Marks and Spencer 341 Marston’s plc 340 matching 474 exchange rate hedging 415 foreign direct investment 295 funding policy 82 interest rate hedging 415 MBI (management buy-ins) 386 MBO (management buyouts) 386–9 McCarthy Taylor 342 Medica Capital 391 merchant bank 113, 474 mergers and takeovers 353, 474 asset-based valuations 363, 365–6 benefits 359 bid defences 379–83 bidding process 378–9 bid premiums 359, 365, 378, 393 case against 358–9 City Code on 374, 378 conglomerate takeover 353 contested bids 359, 379–83 cross-border 359 distinction between 353 divestments following 383–9 earnings per share and 372, 373 economic justifications for 354–6 empirical research on 392–5 financial justifications for 356–8 financing 360, 370–1 cash offers 371–2, 374 costs 359 mixed offers 371, 374 security packages 374 share-for-share offers 357, 359, 372–4, 374 vendor placings and vendor rights issues 374 horizontal takeover 353 income-based valuations 363 justifications for acquisitions 354–9 leveraged 372 managerial motives for 358 private equity 389–91 regulation and control 375–7 shareholder wealth and 354, 356, 357, 380, 393–4 stock market valuation 363–5 strategic and tactical issues 375–83 target company valuations 363–74 tax considerations 357, 359 terminology of 353–4 trends 359–63 vertical takeovers 353, 355 MetLife 440–1 mezzanine finance 371, 388, 474 micro-assessments of political risks 441–2 Micro Focus 334 Microsoft 110 Midland Bank plc 359 Miller and Modigliani 302–5, 324–6, 330, 343–4 moderate working capital policy 79 Mojang 110 money future value of time value of 2–3 money markets 94, 475 hedges 417–18 monopoly power 392 monopoly profits 356 Moody’s Investors Service 140, 141 Morgan Stanley 298, 339, 362, 395 Morrisons, Wm 339 Mothercare 119–20, 138 492 Z04 Corporate Finance 44310.indd 492 23/01/2019 20:15 www.freebookslides.com INDEX multiple-period capital rationing 191 mutually exclusive investment projects 181–3 Mylan 379 National Grid 339, 353 Nationwide 144 NatWest 144 NEDs (non-executive directors) 21 net asset turnover 56 net asset values 365–6 net income approach to capital structure 302–5 net present value (NPV) 5, 12 advantages of 177 base-case 293 calculation of 174–6 capital rationing 185–7 cost of capital 274 decision rule 174 disadvantages of 177 divestments and 384 expected 214–16 inflation 208–10 investment appraisal 174–6 method discount rate changes 184 IRR method compared 181–5 non-conventional cash flows and 183 reinvestment assumptions 184 positive 174, 325 superiority of 185 taxation 205–6 net profit margin 56 net realisable values 365–6 net working capital 58, 78 Netflix 361 netting 415–16, 475 new issues bonds 135 costs 274–5 equity 284, 309 costs 277 initial public offering 109, 110–11 introduction 112 placing method 109–11 public offer 111 underwriting 113 New Look 138 new market entry 355 Nintendo 121–2 nominal cost of capital 207 nominal return 475 nominal value 50, 107, 475 non-conventional cash flows 183 non-cumulative preference shares 125 non-current asset turnover 58 non-current assets 3, 50, 82, 475 non-deferrable investment projects 191 non-executive directors (NEDs) 21, 475 non-participating preference shares 126 non-pecuniary benefits 340–2, 475 non-recourse factoring 98–9, 475 NPV see net present value Numis 334 Nvidia 122 NYSE Euronext 419 obsolescence problem 156 off-balance-sheet financing 475 Office of Fair Trading (OFT) 375–6 Official List 475 Ofgem 291 Oftel 291 Ofwat 291–2 operating gearing 475 operating lease 155 operating policies 443 operating profits 300 operational efficiency 41, 42, 380 opportunity cost 201–2, 475 retained earnings 38–9, 275 optimal allocation of resources optimal investment policies 325 options 121–7, 475 American 422 call 139, 422, 423, 424 hedging with advantages and disadvantages 426–7 exchange rate risk 417, 421, 424–5, 426 interest rate risk 417, 421, 422–4, 426 over-the-counter 421–2, 427 put 422, 423, 424 see also traded options ordinary bond 147 ordinary share account 50, 107 ordinary share capital see equity finance ordinary shareholders 108 rights of 107–8 ordinary shares 3, 37, 475 bonds converted into see convertible bonds cost of capital 274–5, 277–8, 289 private companies 289 see also new issues; rights issues 493 Z04 Corporate Finance 44310.indd 493 23/01/2019 20:15 www.freebookslides.com INDEX overdraft 79–80, 290 over-exposure 240 over-the-counter (OTC) swaps 427 over-the-counter (OTC) derivatives 416, 475 over-the-counter (OTC) options 421–2, 427 overtrading 85–6, 475 Pac-man defence 383 participating preference shares 126 payables see accounts payable payback method advantages of 170 disadvantages of 170–1 discounted 170, 192 example of 169–70 investment appraisal 213 shortening 213 time value of money 170 payback period 169 payout ratios 62–3, 331, 332–5, 343, 475 PayPal 110 pecking order theory 308–10 pension funds 328 People’s Bank of China (PBoC) 188, 410–11 peppercorn rent 475 perfect markets 41–2, 263, 302, 306, 324 performance-related pay (PRP) 16 perks, shareholder 340–2 permanent current assets 82, 475 permanent interest-bearing shares (PIBs) 139 perpetual sub bonds (PSBs) 139 perpetuity 5, 475 Perrigo 379, 395 Persimmon 333 personal debt 304 personal taxation 308, 310, 331, 336, 343 Petrobras 139–40 Philadelphia Stock Exchange 424 PIBs (permanent interest-bearing shares) 139 Pimco 144 placing method 109–11 placings 374 plain vanilla swaps 429–30 poison pills 380, 475 political risks 295, 441–3, 475 Polly Peck plc 10, 20 portfolio theory 214, 239, 245, 247–50, 265 portfolios betas 257, 263 capital market line (CML) 248 diversification 239–45, 252, 262, 438–9 efficient frontier 248–9, 250 market 248, 265 three-share 244–5 two-share 240–4 pre-emptive right 108, 475 preference shareholders 108 preference shares 37, 277, 475 advantages of 126–7 constant stated market value 126 convertible 126 cost of capital 275, 278, 289 cumulative 125 disadvantages of 126–7 dividends 277 mergers and takeovers 374 non-cumulative 125 non-participating 126 participating 126 popularity of 126 variable rate 126 Premier Inns 386 premiums bond redemption 139 conversion 146 rights 146 risk 214 shares 107 Preqin 390 present values 4–5, 475 adjusted present value method 293 annuity perpetuity tables price/earnings (P/E) ratios 62, 343, 367–8, 370, 372 prices cum dividend 321–2 shares see shares pricing efficiency 41–2 transparency, futures 421 primary markets 39, 475 primary ratio 55 prior charge capital 59, 125 private equity 387–8 probability analysis 214–15, 236–7 profit centres 434 profitability 64, 78 profitability index 185–91, 475 profitability ratios 54, 55–7 profits accounting 10, 172 494 Z04 Corporate Finance 44310.indd 494 23/01/2019 20:15 www.freebookslides.com INDEX accumulated net realised 322–3 announcements and forecasts 382 average 173 distributable 39, 300 economic 10, 66–8 gearing levels and 309 maximisation 10 monopoly 356 operating see operating profits quantitative difficulties 10 timescale for maximisation 10 project betas 284, 293 project-specific cost of capital 293 project-specific weighted average cost of capital 284 PRP (performance-related pay) 16 Prudential 144 PSBs (perpetual sub bonds) 139 Public Company Accounting Oversight Board USA 25 public offer 112 Punch Taverns 385 purchase price 157 put options 422, 423, 424, 475 quantitative analysis, of political risk 442 quick ratio 59, 475 quotation, stock exchange 114 raising funds random walk hypothesis 43, 475 ratio analysis 54–65, 67 real cost of capital 207, 475 real option 475 receivables see trade receivables recourse 476 recourse factoring 98–9 redeemable bonds 15–2, 276, 278 redemption bonds 137–9 values (RV) 276 yields 476 refinancing 137, 476 Regal 40 regeared betas 283, 284 regression analysis 254, 264 reinvestment assumptions 184 reinvestment rate 476 remuneration 24–5 directors 22 managerial 16 Rentokil 395 repayment schedule 143 replacement costs 366, 370, 476 required rate of return on equity 284 gearing and 299–300 restrictive covenants 137, 307 retained earnings 13, 37, 476 cost of capital 274, 275, 284 dividend decisions and 321 opportunity cost of 38–9 pecking order theory 308–10 return of the market 257–61, 264 determining 257–61 return on capital employed (ROCE) 54, 55, 338 advantages of 173 calculation of 172 decision rule 172 definition 171 disadvantages of 173–4 return on equity 61 returns abnormal 42–3 mean 237, 238 standard deviation 236–7 see also required rate of return; risk-free rate of return; risks and returns returns on investment 219 revaluation reserve 52 revenue/net working capital ratio 58, 84 rights issues 298, 476 cum rights price 115 deep discount 119 market price after 116–18 shareholder wealth 116 theoretical ex-rights price 116 underwriting 119 value of 115 vendor 374 rights premium 146 Rio Tinto 124 Ripon 144 risk and return equity finance 108 relationship between 3–4 risk averse 476 risk classes 214 risk management political risks 441–3 pros and cons 435–9 strategies 432–5 risk premiums 214, 476 business 300 495 Z04 Corporate Finance 44310.indd 495 23/01/2019 20:15 www.freebookslides.com INDEX risk premiums (Continued) equity see equity risk premiums financial 300 global 293 market see equity risk premiums risk profile 137 risk-adjusted discount rates 214, 293 risk-averse company 210 risk-free benchmarks 258–9 risk-free rate of return 213, 476 borrowing at 248, 250 cost of equity determined by 303 estimates of 264, 284 gearing and 299–300 lending at 248, 250 Treasury bill yield and 248 risks aversion 245, 246, 249, 476 cash flows 11 counterparty 432 currency 295 default 94 downside 210–11, 423 economic 414 empirical analysis 224–5 equity finance 277 gearing and 65 investment appraisal and 210–16 investor attitudes to 245–7 loving 245, 250 meaning measurement of 236–9 neutrality 245 premium 476 political 295, 441–3, 475 and return see risk and return time value of money and unsystematic 14 utility curve analysis and 245–7 risks and returns historical data 238–9 linear relationship between 249, 253, 262, 265 portfolio theory 239, 245, 247–50 probability analysis 236–7 risky investment RJR Nabisco 372 ROCE see return on capital employed rolling average marginal cost of capital 282 rolling cash budget system 92 Royal Bank of Scotland 81, 201 Royal Dutch Shell 334, 337 Royal Mail 201 R-squared 255–6 running yields 476 RV (redemption values) 276 SABMiller 372–4 Sachem Head 385, 386 Sainsbury, J plc 334 sales maximisation 10 Sanofi 391 Sanpower 138 Santander UK 144 Sarbanes-Oxley Act, USA (SOX) 25–6 Scottish Mortgage Investment Trust 242 scrip dividends 123, 336, 476 scrip issues 120–1 see also bonus issue secondary markets 39, 476 secured bond 136 secured creditors 108 securities betas of 254–7 see also shares securitisation 143, 476 security market line (SML) 253, 262, 264–5, 476 security packages 374 sell rates 412 sell-offs 384 semi-strong form efficiency 42–3 semi-strong form tests 44 senior debt 476 sensitivity analysis 442, 476 application of 211–13 description 210–11 key variables 212 separation theory 250 serial correlation 43 Severn Trent 292 SGX (Singapore Exchange) 420 share buybacks 123 share dividend 123 share option schemes 16, 476 share premium account 107 share split 120–1, 476 shareholders agency theory 13–20, 358 dividends 10 expectations 321 financial performance 49 496 Z04 Corporate Finance 44310.indd 496 23/01/2019 20:15 www.freebookslides.com INDEX mergers and takeovers and 393–4 non-pecuniary benefits 340–2 ordinary 108 pre-emptive circulations to 382 preference 108 stock exchange quotation 114 value maximisation 8–9 wealth maximisation 11–13, 324, 380 rights issues 116 shareholding levels, implications and legal obligations 376 shares dividends, effect on 324–30 price behaviour 47–8 prices dividend growth model calculation of 329 dividends, effect on 326, 331, 343 repurchases 123, 336–7, 380 valuation using capital asset pricing model 253–63 Shazam 110 Shire 362 shortening payback method 213 short-term bank loan 80 short-term borrower 80–1 short-term cash surpluses 93–4 short-term finance 79–81, 290, 294 short-term interest rate contracts (STIR) 419 short-term interest rates 80 short-term loan 80 short-termism 297 simulation model 217 Singapore Exchange (SGX) 420 single-period capital rationing 190–1 sinking fund 137, 476 size effect in mergers and takeovers 393 Sky 361 Skype 110 small and medium-sized enterprises (SMEs) 81–2 Smart Metering Systems 41 SME Alliance 81 SMEs (small and medium-sized enterprises) 81–2 smoothing interest rates 415 social responsibility 11 Société Générale 437 soft capital rationing 187–9 Sonia (the Sterling Overnight Index Average) 407–8 sources of finance 309–10 SOX (Sarbanes-Oxley Act, USA) 25 special dividends 338–9, 476 specific inflation 207–8 specific risks betas 255–6 see also unsystematic risk speculative bond 141 spin-offs 384–5 SpiritPub 385 spot market 476 spot rates 412–13 Spotify 110 spread, exchange rates 412, 476 Sprint 362 stakeholders 8, 476 Standard & Poor’s Corporation 140 standard deviation of returns 236–7 standard errors, betas 255–6 Sterling certificates of deposit 94 sterling commercial paper 476 Sterling Overnight Index Average (SONIA) 476 sterling–dollar exchange rates 409 Stewardship Code UK 18–19 STIR (short-term interest rate contracts) 419 stock (securities) 476 stock exchange quotation advantages 113–14 costs of quotation 114 disadvantages 114 finance access 113 raising finance 113 shareholder expectations 114 users of shares 113–14 stock market credibility on 297 diversification 240 efficiency 357 indices 259, 265 share repurchases 336–8 valuations, target companies 365, 367, 370 stock split 120, 476 Stonepeak Infrastructure Partners 391 straight bond 147 strike prices 423, 425, 476 strong form efficiency 43 strong form tests 44–5 subordinate debt 476 subsidiaries, guarantees by holding companies 294 sub-underwriters 113 sunk costs 200, 476 supply chain bullying 96 497 Z04 Corporate Finance 44310.indd 497 23/01/2019 20:15 www.freebookslides.com INDEX survival 10–11 swaps 416, 476 advantages and disadvantages 432 basis 431 counterparty risks 432 credit default 258–9, 437 credit derivatives 432 currency 431–2 exchange rate risk management 427, 432 futures 427 interest rate 427–31 plain vanilla 429–30 swaptions 432, 476 synergy 355, 356, 359, 383, 476 systematic risks 476 CAPM and 252, 253, 262, 262, 264, 265, 284, 293 diversification 239–45 equity betas 283 meaning 239 T-Mobile 362 Takeda 362 Takeover Panel 377, 379, 380 TalkTalk 386 tax allowable costs 204 tax credits dividends 338 share repurchases 338 tax efficiency 136 tax exhaustion 157, 307–8, 357, 477 tax shield 477 tax-allowable depreciation 155, 202–4, 476 taxation advance corporation tax (ACT) 338, 344 benefits 205 capital investment decisions 202–7 debt finance 305 dividends see dividends foreign direct investment and 220 hedging benefits 436 ignoring in investment appraisal 206–7 income tax 328, 336, 343 interest payments 204–5 investment appraisal 202–7 leasing 155, 156 liabilities 205 NPV calculation 205–6 share repurchases 336–8 takeovers 357, 359 technical analysis 42, 47, 477 Tencent 110 tender offers 338, 477 term deposits 93–4 terminal values 219, 369, 477 Thames Water 291 The Restaurant Group 341 theoretical ex-rights price 115 ticks 419, 477 time preference 214 time value of money 2–3, 477 traded options 426 Time Warner 141–2, 149, 391 Tobin’s separation theory 250 total shareholder return 477 Toys R Us 138, 391 trade credit 80 trade payables 477 days 57 deferral period 83 ratio 57 trade receivables 477 collection system 95–6 credit analysis system 95 credit control system 95 days 57 early payment discounts 98 factoring 98–9 insurance against bad debts 97 invoice discounting 99 management 94–100 period 83 ratio 57 traded options 418, 422, 477 call 422, 423, 424 exchange rate risk hedging 424–5 exchange rate risk hedging 426 in the money 426 interest rate risk hedging 422–4 interest rate risk hedging 426 intrinsic value 426 out of the money 426 prices of 425–7 put 422, 423, 424 strike prices 423, 425 time to expiry 426 time value 426 writing 423 transactions costs 253, 262, 304 risks 413, 477 498 Z04 Corporate Finance 44310.indd 498 23/01/2019 20:15 www.freebookslides.com INDEX transfer price 218, 477 translation risk 413–14, 477 Treasury bills 39, 93, 94, 248, 258, 260, 300, 406, 477 Trump, Donald 361, 409–11, 440 Turnbull Report 21 Twitter 148, 149 Tyson Report 21 UK Asset Res1olution (UKAR) 144 UK Corporate Governance Code 21, 23–4 UK Listing Authority (UKLA) 109, 112 UK share ownership 20 UK Stewardship Code 18–19 uncertainties 477 cash flows 207 equity finance 277 payback method 170 risks and, difference between 210 unconventional cash flows 477 undercapitalisation 85–6 see also overtrading underhedging 421 underlying assets 422, 477 undervaluation of target companies 357 underwriting 112–13, 477 new issues 113 rights issues 119 ungeared betas 283, 284 unique risk see unsystematic risk unit trusts 250, 251–2 United Utilities 292 unsecured bond 136 unsecured creditors 108 unsystematic risks 14, 477 betas 257 conglomerate takeovers 356 diversification 247, 252, 262 meaning 239 upside risk 477 US Treasuries 258 utility companies 291 utility curves 245–7 see also indifference curves utility maximisation 245, 252 value stocks 48 values conversion see conversion value destruction by diversification 394 redemption 276 of rights 115 vanilla 477 variability, betas 255–6 variable rate preference shares 126 variation margin 418, 421 vehicle currencies 427 vendor placings 374 vendor rights issues 374 venture capital 387, 388, 477 vertical merger 477 vertical takeovers 353, 355 Virgin 387 Virgin Megastore 387 Vodafone 291, 336, 359 volatility cash flow 240, 356 countries 442 distributable profits 300 equity returns 296 exchange rates 426 operating profits 300 Vornado Realty Trust 391 WACC see weighted average cost of capital warehouse 477 warehousing swaps 427 warrants 477 gearing effect of 150 intrinsic value of 149–50 Water UK 292 weak form efficiency 42 weak form tests 43–4 wealth maximisation managers 358 shareholders see shareholders weekend effect 47 weighted average cost of capital (WACC) 260, 477 after-tax 292 book value weightings 279–81, 290 calculation of 274, 278–81, 289–92 capital asset pricing model and 282 curves 300, 301, 310 foreign direct investment 293 gearing levels and 300, 301, 310 market value weightings 279–81, 290 mergers and takeovers valuations 370 minimum 299 project-specific 284 Whitbread 385–6 white knights 383, 477 withholding tax 477 499 Z04 Corporate Finance 44310.indd 499 23/01/2019 20:15 www.freebookslides.com INDEX working capital 477 cash conversion cycle 82–5 financing 82 incremental 202 inflation 208 investment 218 level of 79 management 78 net 78 overtrading 85–6 policies 78–82 working capital cycle 58 work-in-progress (WIP) 478 WorldCom 20, 21, 25 writing traded options 423 Wuji Wnhua 138 Young & Co’s Brewery 341 Young’s 41 Zavvi 387 zero coupon bonds 142, 478 zero-coupon certificates 94 zero dividend policies 331 zero sum game 159, 478 Zheshang Bank 188 500 Z04 Corporate Finance 44310.indd 500 23/01/2019 20:15 www.freebookslides.com What’s new? • Chapter vignettes are refreshed and the accompanying questions are updated with the aim of deepening student’s knowledge of key contemporary issues • Up to date with the latest changes in regulations and taxation, such as the UK tax treatment of dividends Join over 10 million students benefiting from Pearson MyLabs This title can be supported by MyLab Finance, an online homework and tutorial system designed to test and build your understanding MyLab Finance provides a personalised approach, with instant feedback and numerous additional resources to support your learning It includes: • • • • • A personalised study plan Usable either following chapter-by-chapter structure or by learning objective New questions and case studies to help you apply what you’ve learned Worked solutions showing you how to solve difficult problems Limitless opportunities to practise Use the power of MyLab Finance to accelerate your learning You need both an access card and a course ID to access MyLab Finance: Is your lecturer using MyLab Finance? Ask your lecturer for your course ID Has an access card been included with the book? Check the inside back cover of the book If you have a course ID but no access card, go to www.pearson.com/mylab/finance to buy access Front cover image © Denzil Watson CVR_WATSON_08_44310.indd Eighth edition DENZIL WATSON & ANTONY HEAD CORPORATE FINANCE PRINCIPLES AND PRACTICE Eighth edition WATSON & HEAD Denzil Watson is a Principal Lecturer and Antony Head is an Associate Lecturer at the Sheffield Business School, Sheffield Hallam University They have extensive experience of teaching corporate finance, managerial finance and strategic financial management over many years and in a wide range of courses at undergraduate, postgraduate and professional level CORPORATE FINANCE In this new and fully updated eighth edition, the core concepts and topics of corporate finance are introduced in an approachable, user-friendly style Key principles and mathematical techniques needed for a career in business are clearly explained step by step and are put into practice through numerous examples and vignettes which take a closer look at real-world and well-known companies www.pearson-books.com 15/01/2019 13:08 ... F01 Corporate Finance 44310 Contents.indd 23/01/2019 14:38 CORPORATE FINANCE PRINCIPLES AND PRACTICE Eighth edition Denzil Watson and Antony Head Sheffield Hallam University Harlow, England •... Cataloging-in-Publication Data Names: Watson, Denzil, author | Head, Antony, 1953- author Title: Corporate finance : principles and practice / Denzil Watson and Antony Head, Sheffield Hallam... Michael and Robert, and six grandchildren: Joshua, Isaac, Elizabeth, Amelia, Magnus and Arlo, with a seventh grandchild on the way Photo: Denzil Watson Denzil Watson is a Principal Lecturer in Finance