Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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x Contents

14.7 Cash management models 372

Summary 373

Key points 373

Further reading 672

Appendices

A Solutions to self-assessment

activities 673

B Solutions to selected questions 691

C Present value interest factor (PVIF) 722

D Present value interest factor for an annuity

(PVIFA) 724

Glossary 726

References 735

Index 743

Supporting resources

Visit www.pearsoned.co.uk/pikeneale to find valuable online resources:

Companion Website for students

■ Summary of each chapter to aid revision

■ Self-assessment questions to check your understanding

■ Annotated links to relevant sites on the Internet

■ An online glossary to explain key terms

■ Quests per chapter to improve information seeking skills.

For instructors

■ Complete, downloadable Instructor’s Manual including summary of question materi-

al and answers to all questions not answered in the book itself

■ Extra question and answer material for use in class or for examinations

■ Case studies for more in-depth discussion on practical issues

■ PowerPoint lecture slides that can be downloaded and used as OHTs.

Also: the Companion Website provides the following features:

■ Search tool to help locate specific items of content

■ E-mail results and profile tools to send results of quizzes to instructors

■ Online help and support to assist with website usage and troubleshooting.

For more information please contact your local Pearson Education sales

representative or visit www.pearsoned.co.uk/pikeneale.

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List of figures and tables

List of figures

1.1 The finance function in a large organisation 6

1.2 Cash–the lifeblood of the business 7

1.3 The risk–return trade-off 16

1.4 Main elements in strategic planning 17

1.5 Factors influencing the value of the firm 18

2.1 Financial markets, institutions, suppliers

and users 26

2.2 Chart showing breakout beyond

resistance line 36

3.1 The relationship between present value

of £1 and interest over time 68

3.2 Investment appraisal elements 73

3.3 The term structure of interest rates 78

3.4 Investment opportunities for Platt Enterprises 81

3.5 Investment and financing opportunities

for Platt Enterprises 82

3.6 Investment decisions in imperfect capital

markets 84

4.1 Calculating free cash flow (FCF) 102

4.2 Shareholder value analysis framework 109

5.1 Lara proposal: NPV–IRR graph 127

5.2 NPV and IRR compared 133

7.1 McKinsey–GE portfolio matrix 175

7.2 Normal progression of product over time 176

7.3 Investment strategy 177

7.4 A simple capital budgeting system 183

8.1 Risk profiles 198

8.2 Risk-averse investor’s utility function 198

8.3 Variability of project returns 201

8.4 Mean–variance analysis 203

8.5 Sensitivity graph 204

8.6 Simulated probability distributions 207

8.7 How risk is assumed to increase over time 209

9.1 Equal and offsetting fluctuations in returns 220

9.2 Available portfolio risk-return

combinations when assets, risks and

expected returns are different 227

9.3 The effect on the efficiency frontier of

changing correlation 228

9.4 Gerrybild’s opportunity set 231

9.5 Portfolio combinations with three assets 232

10.1 Total Shareholder Return (TSR) 240

10.2 Specific vs. market risk of a portfolio 241

10.3 The effect of international diversification

on portfolio risk 243

10.4 Combining the Warsaw and the

London markets 244

10.5 The characteristics line: no specific risk 245

10.6 The characteristics line: with

specific risk 246

10.7 The security market line 249

10.8 The capital market line 256

10.9 The CAPM: the three key relationships 258

10.10 Theoretical and empirical SMLs 260

10.11 Alternative characteristics lines 267

11.1 Risk premiums for activities of

varying risk 283

11.2 The Beta pyramid 284

12.1 Payoff lines for share options in Enigma

Drugs plc 298

12.2 BP call option 302

12.3 BP put option 303

12.4 Option and share price movements for

Bradford plc 306

12.5 The value of the options to delay

investments: Cardiff Components Ltd 312

13.1 Financing working capital: the matching

approach 327

13.2 Financing working capital needs: an

aggressive strategy 328

13.3 Yield curves 329

13.4 Cash conversion cycle 341

13.5 Helsinki plc working capital strategies 343

13.6 Optimal level of working capital for a

‘relaxed’ strategy 345

13.7 Optimal level of working capital for an

‘aggressive’ strategy 345

14.1 The credit management process 355

14.2 Ordering and debt collection cycle 359

14.3 The inventory cycle 364

14.4 Cash flow activity for main stakeholders 368

14.5 Miller-Orr cash management model 375

15.1 How hire purchase works 390

16.1 How an SPV works 434

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xiv List of figures and tables

17.1 The impact of a permanent dividend cut 453

17.2 Dividends as a residual 456

18.1 How gearing affects the ROE 488

18.2 The ‘traditional’ view of capital structure 491

19.1 MM’s Propositions I and II 517

19.2 The MM thesis with corporate income tax 521

19.3 Business and financial risk premia and the

required return 524

19.4 Optimal gearing with liquidation costs 527

20.1 A strategic framework 559

20.2 Type of acquisition and integrative

complexity 564

21.1 Sterling exchange rates, 1999–2004 595

21.2 Interlocking theories in international

economics 606

21.3 Flow chart demonstrating a logical

approach towards devising a foreign

exchange management strategy 611

21.4 Illustration of multiple netting 614

21.5 Achieving the swap 623

22.1 Alternative modes of market entry 633

22.2 Exporting vs. FDI 635

22.3 Classification of firms by extent of

operating exposure 642

22.5 A simple APV model 655

A.1 Portfolio combinations with four assests 680

List of tables

2.1 Share price information for the food

retail sector 45

2.2 Foto-U plc 49

2.3 Foto-U key ratios 51

2.4 Foto-U annual corporate performance report 55

3.1 Compound interest on £1,000 over five

years (at 10%) 63

3.2 Annual percentage rates for a loan with

interest payable at 22 per cent per annum 64

3.3 Present value of a single future sum 68

4.1 Balance sheet for DS Smith plc as at

30 April 2004 91

4.2 Football clubs quoted on the London Stock

Exchange 94

4.3 How earnings and dividends grow in

tandem (figures in £m) 106

4.4 Calculation of EVA 112

5.1 Net present value calculations 124

5.2 Why NPV makes sense to shareholders 124

5.3 IRR calculations for Lara proposal 126

5.4 Payback period calculation 128

5.5 Calculation of the ARR on total assets 130

5.6 Comparison of various appraisal methods 131

5.7 Comparison of mutually exclusive projects 133

5.8 Investment opportunities for Mervtech plc 136

5.9 NPV vs. PI for Mervtech plc 136

5.10 Modified IRR for Lara 139

5.11 Flintoff plc: planned investment schedule

(£000) 140

5.12 Projects accepted based on LP solution 141

6.1 Profitability of Sevvie’s project 152

6.2 Sevvie plc solution 152

6.3 The money terms approach 153

6.4 The real terms approach 154

6.5 Project Tiger 2000 (assuming no capital

allowances) 155

6.6 Woosnam plc – Tiger 2000 tax reliefs 156

6.7 Woosnam plc – Tiger 2000 with tax relief 157

6.8 Capital investment evaluation methods

in 100 large UK firms 158

6.9 Relationship between ARR and IRR 160

6.10 Allis plc cash flows for two projects 164

6.11 Profit projection for CNC milling

machine (£000) 171

8.1 Betterway plc: expected net present values 197

8.2 Effects of cost structure on profits (£000) 199

8.3 Snowglo plc project data 200

8.4 Project risk for Snowglo plc 201

8.5 UMK cost structure 205

8.6 Risk analysis in 100 large UK firms 210

8.7 Bronson project payoffs with independent

cash flows 212

9.1 Returns under different states of the

economy 224

9.2 Calculating the covariance 224

9.3 Differing returns and risks 226

9.4 Portfolio risk-return combinations (%) 226

9.5 Returns from Gerrybild 229

9.6 Calculation of standard deviations of

returns from each investment 229

9.7 Calculation of the covariance 230

10.1 The annual TSRs on Pilkington shares 239

10.2 How to remove portfolio risk 242

10.3 Possible returns from Walkley Wagons 245

10.4 Beta values of the constituents of

the FT 30 Share Index 248

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List of figures and tables xv

10.5 Equity-gilts relative returns 252

11.1 The return on Whitbread plc shares 273

11.2 Cash flow profile for Safa plc

(ungeared) 281

11.3 Divisional Betas for Whitbread plc 285

11.4 The effect of operating gearing (£m) 287

11.5 Subjective risk categories 288

12.1 Option on BP shares (current price 397p) 300

12.2 Returns on BP shares and options 301

12.3 Valuing a call option in Riskitt plc 308

12.4 Harlequin plc: call option valuation 313

13.1 Helsinki plc: profitability and risk of

working capital strategies 344

14.1 Total inventory levels and stockholding

periods 363

14.2 Thorntons plc consolidated cash flow

statement 369

14.3 Mangle Ltd: production and sales 371

14.4 Mangle Ltd: cash budget for six months

to June (£) 371

15.1 Tax relief on a 3-year HP contract with

4-year asset lifetime (£) 391

15.2 Hardup plc’s leasing analysis 394

15.3 The behaviour of the equivalent loan (£m) 395

15.4 Hardup’s leasing decision with tax 399

15.5 Interest charges on a lease contract

(figures in £m) 400

15.6 Changes in tax-allowable lease costs

(figures in £m) 400

16.1 History of Microsoft common

stock splits 431

17.1 Kelda Group plc Financial Calendar 2004 448

17.2 Rawdon plc 460

17.3 BAA plc: dividend smoothing 464

17.4 Analysis of a share repurchase 467

18.1 Financial data for BAA plc 483

18.2 How gearing affects shareholder returns in

Lindley plc 487

18.3 How gearing affects the risk of ordinary

shares 488

18.4 How gearing can affect share price 489

19.1 Key definitions in capital

structure analysis 515

19.2 The tax shield with finite-life debt 531

20.1 The scale and financing of takeover

activity of UK firms by UK firms 543

20.2 Acquisition according to status of acquiree 544

20.3 Cross-border acquisitions involving UK

companies 545

20.4 Hawk and vole 551

20.5 Strategic opportunities 560

20.6 Pre- and post-bid returns 569

20.7 The gains from mergers 570

21.1 Average rates against sterling 594

21.2 Twelve-month forecasts to

1 November 2000 609

21.3 Oilex’s internal currency flows 615

21.4 Sterling/US$ options 619

22.1 Sparkes and Zoltan: project details 640

22.2 Evaluation of the Zoltan project 641

22.3 Alternative evaluation of Zoltan project 641

22.4 Country risk scores for selected locations 649

22.5 British Airways plc borrowings as at 31

March 2004 653

CFAI_A01.QXD 3/15/07 7:05 AM Page xv

Not all text-books survive to a fifth edition. As one of the lucky survivors, we wish to

preface this edition with another ‘thank you’ – thank you to the lecturers who have

recommended our book and also to the students who have purchased and used it.

Hopefully, you have all obtained good value from it.

We first began work on this project around 1990, a decade and a half ago. Over this

period, there have been many changes in the financial arena. For example, a radical

downshift in inflationary expectations, the formation of the World Trade Organisation,

increasing integration of world financial markets, powered by the ongoing revolution

in communications, the end of the ‘Japanese Miracle’, and the introduction of the euro.

We have seen several financial meltdowns – at the national level, the ‘Asian Crisis’,

Argentina, and at the micro-level, the ‘dotcom’ boom and bust and the crisis in corpo-

rate governance.

It is not surprising that financial issues increasingly dominate the news bulletins,

emphasizing the need for both students of business and also business practitioners to

have at least a working knowledge of finance. Yet academic courses are becoming

increasingly fragmented, for example, with the move to semesterisation. At the same

time, within academic courses, the emphasis now placed on formal mathematical and

statistical training, and even economics, is also being reduced.

These considerations reinforce our view that finance should be about developing,

explaining and, above all, applying key concepts and techniques to a broad range of

contemporary management and business policy concerns and challenges. It is becom-

ing more appropriate, certainly at the undergraduate level, to demonstrate the role

finance has to play in explaining and shaping business development rather than con-

centrating on rigorous, quantitative aspects.

The focus of the fifth edition, as in previous ones, is distinctly corporate, examining

financial issues from a managerial standpoint. To simplify greatly, we have tried, wher-

ever possible, to present the reader with the question ‘OK, but how does this help the

managerial decision-maker?’ and also to provide a few answers, or at least pointers.

Some might say we should include chapters on other financial issues deemed to

have a degree of importance equivalent to those covered here. Yet we believe, as ever,

that there is a trade-off between comprehensiveness and manageability. Admittedly,

this edition has grown a little but it is directed at those issues, which in our experience

are regarded as the central issues in finance.

Distinctive features

The fifth edition retains a set of distinctive features, including the following:

■ A strategic focus. Students often regard financial management as a subject quite dis-

tinct from management and business policy. We attempt to relate the subject to

these matters, emphasizing the integration of the finance function within the con-

text of managerial decision-making and corporate planning, and to the wider exter-

nal environment.

■ A practical approach. Financial theory increasingly dominates some texts. Theory has

its place, and this text covers an appreciable amount; however, we seek to blend the-

ory and practice: to ask why they sometimes differ, and to assess the role of less-

sophisticated financial approaches. In other words, we do not elevate theory above

common sense and intuition.

Preface

CFAI_A01.QXD 3/15/07 7:05 AM Page xvi

Preface xvii

■ A clear and accessible style. Personal experience and feedback suggests that much of

our target readership prefers a more descriptive, rather than heavily mathematical,

approach but appreciates worked examples and illustrations. There is a place for

formulae, proofs and quantitative analysis; however, where possible, an alternative

narrative explanation is provided. Appendices are often used to deal with rather

more complex mathematical aspects.

■ An international perspective. Although emanating from the UK, our text uses, where

appropriate, examples drawn from other regions and countries, especially main-

land Europe and the USA.

Teaching and learning features

A range of teaching and learning features is provided, including the following:

■ Mini-case studies. Topical cameos, applying financial management principles to

well-known companies, are presented at the start of chapters and elsewhere with-

in the text.

■ Learning objectives. Specified at the outset of each chapter, these highlight what the

reader should achieve in terms of concepts, terminology and skills.

■ Worked examples. Integrated throughout the text to illustrate the key principles.

■ Extracts from the press. Each chapter includes at least one article from either the

Financial Times or the Economist focusing on one of the key issues addressed in the

chapter.

■ Key revision points. Provided at the end of each chapter to summarize the main con-

cepts covered.

■ Annotated further reading. At the end of each chapter, a number of key books and arti-

cles are suggested to offer additional perspectives and enable subjects to be studied

in more depth. Full details of all books and articles are given in the References at the

end of the book.

■ A quick reference glossary of simple definitions.

Assessment features

Flexible study and assessment is facilitated by a variety of activities:

■ Self-assessment activities (SAAs). These include both short questions and simple

numerical exercises designed to reinforce a point made in the text or to encourage

the reader to pursue a particular line of thought. However, they are presented dif-

ferently and consistently in this edition. Questions are inserted in the text at appro-

priate points and the answers are packaged together at the end of the book.

■ Questions. These test a mix of numerical, analytical and descriptive skills, offering a

spread of difficulty. A selection of solutions is also provided in Appendix A at the

end of the text, making these suitable for self-assessment, tutorial or examination

purposes.

■ Practical assignments. These provide the opportunity to look beyond the confines of

the text to consider the application of concepts to a company or organization, or to

published financial reports and data, and are suitable where group or individually

assessed coursework is set.

Readership

The text has proved successful both for newcomers to finance and also for students

with a prior knowledge of the subject. It is particularly relevant to undergraduate,

MBA and other postgraduate and post-experience courses in corporate finance or

financial management. Students seeking a professionally accredited qualification

will also find it especially relevant to the financial management papers of the

Association of Chartered Certified Accountants, Institute of Chartered Secretaries

CFAI_A01.QXD 3/15/07 7:05 AM Page xvii

xviii Preface

and Administrators, Certified Diploma in Finance and Accounting, Chartered

Institute of Management Accountants and the Institute of Chartered Accountants in

England and Wales.

Changes to the fifth edition

As with previous editions, our revisions are based on extensive market research

including reviewers’ questionnaires and direct feedback from adopters and users.

Feedback, while always interesting and helpful, was sometimes contradictory.

Some wished for a more comprehensive, and sometimes more rigorous treatment,

while others expressed concern that we might lean too far in the direction of strat-

egy. Hopefully, we have achieved a balance between academic rigour and practi-

cal application.

In preparing this edition, we have battled with two opposing forces. We wanted to

avoid expanding the text to an unmanageable size, yet we have been aware of several

gaps in our coverage in previous editions, and the need for ‘infill’.

The main changes to this edition in structure and in content are:

Structural changes

Following comments by reviewers (although not unanimous!), we decided to consol-

idate much on the international material into a whole new Part – Part VI International

finance. This includes the old Chapter 17 on Managing currency risk, that appeared in

Part IV, and also the old Chapter 8 on Foreign investment decisions. This consolidation

has the major advantage of enabling us to draw upon prior treatments of concepts/

theories such as PPP and IRP when we handle FDI, rather than attempting to cover

these in ‘broad-brush’ form as we did in the old Chapter 8. Consequently, the old

Section 8.6 (entitled ‘Should firms worry about exchange rate changes?’) has been

incorporated into the new Chapter 21. The new Chapter 22 now incorporates sections

that were previously dispersed across other chapters – specifically, the old Sections

20.9 (International financing) and 20.10 (The WACC for foreign investment projects),

and 21.10 (Applying the APV to foreign investment decisions).

However, we decided that the material on insuring and financing international

trade, the old Section 16.11 (Financing international trade), still properly belongs with-

in the chapter on short- and medium-term finance (the new Chapter 15).

There is now a new Chapter 23 that provides an overview on the ‘state of the art’ in

corporate financial management, and offers important perspectives on the field from

the standpoint of behavioural finance. It thus offers insights into the possible direc-

tions that future developments in this subject might take.

Changes in content

As well as routine revisions and updating, especially of introductory and in-chapter

cameos, we have made the following changes:

The treatment of EVA has been revised and strengthened in Chapter 4, and extend-

ed to cover geared firms in Chapter 18 (formerly Chapter 20).

There is now a new section in Chapter 10 (old Chapter 11) on factor models.

The material in Chapter 12 (formerly Chapter 13) on strategic options has been

strengthened.

Chapter 19 (formerly Chapter 21) now includes a section (Section 21.7 Linking the

Betas) that clarifies the relationship between the various concepts of Beta.

Chapter 20 on Acquisitions and restructuring has been updated to include material

on the new EU Mergers Directive.

CFAI_A01.QXD 3/15/07 7:05 AM Page xviii

Preface xix

Structure and outline

An outline of the text is given below; however, a further description of the purpose

and content of each section is given in the introduction to each.

Part I considers the underlying framework for corporate financing and investment

decisions; key aspects of this part are the financial objectives of business, the financial

environment within which firms operate, the time value of money and the concept of

value.

Part II addresses investment decisions and strategies within firms. Emphasis is

placed on evaluation procedures, including treatments of taxation, inflation and cap-

ital rationing. Because, in practice, investment decision-making often bears little rela-

tionship to the theoretical approaches outlined in some texts, we persist in our

attempt to promote an understanding of the practical evaluation of investment deci-

sions by firms.

The importance of risk management is examined in Part III. Five chapters are

devoted to analysing and managing investment risk: the first considers the investment

project in isolation, while other chapters view risk more from a shareholder perspec-

tive. Fundamental to this section and to the whole of financial management is the rate

of return on investment required by shareholders. The rapidly developing and excit-

ing field of options analysis is also explored.

Part IV discusses the short-term financing decisions and policies for acquiring

assets. It covers treasury and working capital management.

Part V addresses long-term, strategic financing and policy issues. What are the main

sources of finance? How much should a company pay in dividends? How much

should it borrow? The culminating chapter focuses on corporate restructuring with

particular reference to acquisitions.

Part VI examines international financial management issues. It explains the opera-

tion of the foreign currency markets and how firms can hedge against adverse foreign

exchange movements, and sets out the principles underpinning firms’ evaluation of

foreign investment decisions.

Companion website

This edition is supported by a companion website, at www.pearsoned.co.uk/pikeneale.

This contains much of the material that we have included in previous instructors’

manuals. It provides answers to all the end-of-chapter questions, plus additional ques-

tions and answers. The case exercises previously included in Chapter 23 of the third

edition also appear there. It also reproduces the glossary.

CFAI_A01.QXD 3/15/07 7:05 AM Page xix