Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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CORPORATE FINANCE
AND INVESTMENT
DECISIONS & STRATEGIES
fifth edition
Richard Pike & Bill Neale
An imprint of
CORPORATE FINANCE
AND INVESTMENT
fifth
edition
“A book that meets the needs of students at many levels using straightforward clear explanations. Written in
common-sense language that can be understood by students just beginning their studies, as well as offering
complex hypotheses to challenge the more advanced students. It frequently puts the difficult theories in context
by relating them to the practicalities of business examples students can relate to.”
– Dr Ann Butchers, Senior Teaching Fellow, University of Warwick, UK
“Provides a comprehensive coverage of the whole spectrum of corporate finance. Using
simple but powerful examples, as well as a host of real world illustrations, this book carefully
explains the principles, models and intuition financial managers need to have to successfully
create value for their business. What is really excellent is the way that the authors embed
the discussion within the company’s wider corporate strategic context. This is one reason
why I have long used this book as the required text for my corporate finance course.”
– Dr Peter Moles, Senior Lecturer in Finance, University of Edinburgh Management School, UK
New for fifth edition:
• Key formulae printed inside cover for easy reference;
• Increased emphasis given to international aspects by drawing
together relevant material into a new Part VI on International Finance;
• New final chapter provides an overview of the ‘State of the Art’ and
future direction in corporate financial management, including
important perspectives from a behavioural finance view;
• Revised and updated to include the latest thinking on modern topics
such as EVA
®
, strategic options and the new EU Mergers Directive.
This popular text takes a practical approach to corporate finance, applying key concepts and techniques to a broad range of
contemporary issues in the field of finance. Examining financial issues from a managerial standpoint the authors demonstrate
the role finance has to play in explaining and shaping business development, rather than concentrating on quantitative aspects.
Richard Pike is a Chartered Accountant and Professor of Accounting and Finance at the Bradford University School of
Management.
Bill Neale is Associate Reader in Financial Management at the University of Bournemouth Institute of Business & Law. He is
an experienced teacher, consultant and writer, and is the co-author of the Pearson Education text Business Finance: A Value-
Based Approach with Trefor McElroy.
Corporate Finance and Investment is
highly suitable for undergraduates
taking a course in corporate finance
as part of Accounting, Finance and
Business Studies degrees, as well as
those taking MBA and other
postgraduate-level courses in
corporate finance. It is particularly
suitable for those aiming for
professional body qualifications, e.g.,
from CIMA, ACCA or ICAS.
Established distinctive features:
• Reliable and easy to read, the text’s clear and accessible style presents
maths using worked examples and diagrams to aid understanding and
highlight application;
• Practical, problem-solving approach blends theory and practice through a
wealth of real-world examples, mini-case studies and cameos, to help
students to learn how to apply their knowledge;
• Carefully thought-out features throughout the text to encourage learning
and self-assessment;
• Recommended by professional bodies such as CIMA and ACCA.
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Pike & Neale
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CORPORATE FINANCE AND INVESTMENT
DECISIONS & STRATEGIES
Visit the
Corporate Finance and Investment
,
fifth edition
Companion
Website at
www.pearsoned.co.uk/pikeneale to find valuable student
learning material including:
■ Summary of each chapter to aid revision
■ Self-assessment questions to check your understanding
■ Annotated links to relevant sites on the Internet
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■ Quests per chapter to improve information seeking skills.
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CORPORATE FINANCE
AND INVESTMENT
DECISIONS & STRATEGIES
Fifth Edition
Richard Pike and Bill Neale
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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 published 1993
Fifth edition published 2006
© Prentice Hall Europe 1993, 1999
© Pearson Education Limited 2003, 2006
The rights of Richard Pike and Bill Neale 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, 90 Tottenham Court Road, London W1T 4LP.
ISBN: 978-0-273-69561-5
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
1098765432
10 09 08 07
Typeset in 9 /12 pt Palatino by 71.
Printed and bound by Graficas Estella, Spain.
The publisher’s policy is to use paper manufactured from sustainable forests.
1
2
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To our wives, Carol and Jean
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Contents
List of figures and tables xiii
Preface xvi
Guided tour of the book xx
Guided tour of the companion website xxii
Acknowledgements xxiii
Publisher’s acknowledgements xxiv
2.9 Taxation and financial decisions 46
Summary 47
Key points 47
Further reading 47
Appendix: Financial statement analysis 48
Questions 57
Chapter 3
Present values and financial arithmetic
60
3.1 Introduction 61
3.2 Measuring wealth 61
3.3 Time-value of money 62
3.4 Financial arithmetic for capital growth 63
3.5 Present value 65
3.6 Present value arithmetic 68
3.7 Valuing bonds 71
3.8 Net present value 73
Summary 77
Key points 77
Further reading 77
Appendix I: The term structure of interest rates
and the yield curve 78
Appendix II: The investment–consumption decision 79
Appendix III: Present value formulae 84
Questions 86
Chapter 4
Valuation of assets, shares
and companies
88
4.1 Introduction 89
4.2 The valuation problem 89
4.3 Valuation using published accounts 90
4.4 Valuing the earnings stream: P:E ratios 96
4.5 EBITDA – a halfway house 98
4.6 Valuing cash flows 98
4.7 The DCF approach 100
4.8 Valuation of unquoted companies 103
4.9 Valuing shares: the Dividend Valuation Model 104
4.10 Problems with the Dividend Growth Model 106
4.11 Shareholder value analysis 109
4.12 Economic Value Added (EVA) 111
Part I
A FRAMEWORK FOR FINANCIAL
DECISIONS
Chapter 1
An overview of financial management
3
1.1 Introduction 4
1.2 The finance function 5
1.3 Investment and financial decisions 6
1.4 Cash – the lifeblood of the business 7
1.5 The emergence of financial management 8
1.6 The finance department in the firm 9
1.7 The financial objective 10
1.8 The agency problem 11
1.9 Managing the agency problem 12
1.10 Social responsibility and shareholder wealth 13
1.11 The corporate governance debate 14
1.12 The risk dimension 16
1.13 The strategic dimension 17
Summary 20
Key points 20
Further reading 21
Questions 22
Chapter 2
The financial environment
24
2.1 Introduction 25
2.2 Financial markets 25
2.3 The financial services sector 27
2.4 The London Stock Exchange (LSE) 30
2.5 Are financial markets efficient? 34
2.6 A modern perspective – chaos theory 41
2.7 Short-termism in the City 43
2.8 Reading the financial pages 44
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viii Contents
Summary 112
Key points 113
Further reading 113
Questions 114
7.3 Advanced manufacturing technology
(AMT) investment 178
7.4 Environmental aspects of investment 180
7.5 The capital investment process 181
7.6 Post-auditing 188
Summary 190
Key points 190
Further reading 190
Questions 191
Part II
INVESTMENT DECISIONS
AND STRATEGIES
Part III
INVESTMENT RISK AND RETURN
Chapter 5
Investment appraisal methods
121
5.1 Introduction 122
5.2 Cash flow analysis 122
5.3 Investment techniques – net present value 123
5.4 Internal rate of return 125
5.5 Profitability index 127
5.6 Payback period 128
5.7 Accounting rate of return 129
5.8 Ranking mutually exclusive projects 130
5.9 Investment evaluation and capital rationing 134
Summary 137
Key points 137
Further reading 138
Appendix I: Modified IRR 138
Appendix II: Multi-period capital rationing
and mathematical programming 139
Questions 144
Chapter 6
Project appraisal – applications
147
6.1 Introduction 148
6.2 Incremental cash flow analysis 148
6.3 Replacement decisions 151
6.4 Inflation cannot be ignored 153
6.5 Taxation is a cash flow 155
6.6 Use of DCF techniques 157
6.7 Traditional appraisal methods 159
Summary 163
Key points 163
Further reading 164
Appendix: The problem of unequal lives: Allis plc 164
Questions 166
Chapter 7
Investment strategy and process
173
7.1 Introduction 174
7.2 Strategic considerations 174
Chapter 8
Analysing investment risk
195
8.1 Introduction 196
8.2 Expected net present value (ENPV):
Betterway plc 197
8.3 Attitudes to risk 197
8.4 The many types of risk 198
8.5 Measurement of risk 200
8.6 Risk description techniques 204
8.7 Adjusting the NPV formula for risk 208
8.8 Risk analysis in practice 210
Summary 211
Key points 211
Further reading 212
Appendix: Multi-period cash flows and risk 212
Questions 215
Chapter 9
Relationships between investments:
portfolio theory
219
9.1 Introduction 220
9.2 Portfolio analysis: the basic principles 221
9.3 How to measure portfolio risk 223
9.4 Portfolio analysis where risk and return
differ 226
9.5 Different degrees of correlation 227
9.6 Worked example: Gerrybild plc 228
9.7 Portfolios with more than two components 231
9.8 Can we use this for project appraisal?
Some reservations 233
Summary 234
Key points 234
Further reading 234
Questions 235
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Chapter 10
Setting the risk premium: the Capital Asset
Pricing Model
237
10.1 Introduction 238
10.2 Security valuation and discount rates 238
10.3 Concepts of risk and return 239
10.4 The relationship between different equity
markets 243
10.5 Systematic risk 244
10.6 Completing the model 249
10.7 Using the CAPM: assessing the
required return 250
10.8 The underpinnings of the CAPM 254
10.9 Portfolios with many components:
the capital market line 255
10.10 How it all fits together: the key
relationships 257
10.11 Reservations about the CAPM 259
10.12 Testing the CAPM 260
10.13 Factor models 261
10.14 The Arbitrage Pricing Theory 262
10.15 Issues raised by the CAPM: some food
for managerial thought 263
Summary 266
Key points 266
Further reading 266
Appendix: Analysis of variance 267
Questions 269
Chapter 11
The required rate of return on
investment and Shareholder
Value Analysis
271
11.1 Introduction 272
11.2 The required return in all-equity firms:
the DGM 272
11.3 The required return in all-equity firms:
the CAPM 276
11.4 Using value drivers – Shareholder Value
Analysis (SVA) 278
11.5 Worked example: Safa plc 280
11.6 Using ‘tailored’ discount rates 283
11.7 Another problem: taxation and the CAPM 288
11.8 Problems with ‘tailored’ discount rates 289
11.9 A critique of divisional hurdle rates 290
Summary 291
Key points 291
Further reading 292
Questions 293
Chapter 12
Identifying and valuing options
296
12.1 Introduction 297
12.2 Share options 297
12.3 Option pricing 304
12.4 Application of option theory to
corporate finance 309
12.5 Capital investment options 311
12.6 Why conventional NPV may not tell the
whole story 314
Summary 315
Key points 315
Further reading 316
Appendix: Black–Scholes option pricing formula 316
Questions 318
Contents ix
Part IV
SHORT-TERM FINANCING
AND POLICIES
Chapter 13
Treasury management and working
capital policy
323
13.1 Introduction 324
13.2 The treasury function 324
13.3 Funding 326
13.4 How firms can use the yield curve 328
13.5 Banking relationships 329
13.6 Risk management 330
13.7 Working capital management 337
13.8 Predicting corporate failure 339
13.9 Cash operating cycle 340
13.10 Working capital policy 342
13.11 Overtrading problems 346
Summary 348
Key points 348
Further reading and website 348
Questions 349
Chapter 14
Short-term asset management
353
14.1 Introduction 354
14.2 Managing trade credit 354
14.3 Worked example: Pickles Ltd 361
14.4 Inventory management 362
14.5 Cash management 367
14.6 Worked example: Mangle Ltd 370
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