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

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Guided tour of the book

The preceding analysis of investment decisions has implied that future returns from investment can

be forecast with certainty. Clearly, this is unlikely in practice. In Part III we examine the impact of

uncertainty on the investment decision, and the various approaches available to decision-makers to

cope with this problem.

In Chapter 8, we discuss a number of methods that may assist the decision-maker when looking at

the risky investment project in isolation. In Chapter 9, we look at how more desirable combinations

of risk and return can be achieved by forming a portfolio of investment activities. In Chapter 10, we

examine the contribution to risk analysis of the Capital Asset Pricing Model, which offers a guide to

setting the premium required for risk.The earlier study of how capital markets behave is particularly

important here. Chapter 10 is highly important because it links the behaviour of individual investors,

buying and selling securities, to the behaviour of the capital investment decision-maker. This focus is

further developed in Chapter 11, which discusses how to alter the discount rate when faced by

projects of degrees of risk that differ from the company’s existing activities. Finally, in Chapter 12,

we look at the contribution to investment appraisal under risk promised by the rapidly developing

field of option analysis.

Chapter 8 Analysing investment risk 195

Chapter 9 Relationships between investments: portfolio theory 219

Chapter 10 Setting the risk premium: the Capital Asset Pricing Model 237

Chapter 11 The required rate of return on investment and shareholder

value analysis

271

Chapter 12 Identifying and valuing options

296

INVESTMENT RISK AND RETURN

Part

III

Short-term asset management

Learning objectives

Having read this chapter, you should have a good appreciation of the importance of short-term

asset management in corporate finance and of the basic control methods involved. Specific atten-

tion will be paid to the following:

■ Managing trade credit.

■ Inventory management.

■ Cash management.

SOS from ASOS: from hero to zero

For retailers, the most important current asset is

stock. Failure to have on hand the right amount of

stock at the right time results in lost opportunities to

make profits. For a clothing retailer, this is especially

important if the product quickly goes out of fashion,

as these opportunities may never reappear.

ASOS (formerly As Seen On Screen), the online fash-

ion retailer that specialises in selling celebrity-style

clothes to 20-something shoppers, was the top per-

former on the London Stock Exchange during 2004,

when its shares rose from 5p to 78p. However, in March

2005, it was forced to issue a profits warning.As a result

of problems with distribution of merchandise, winter

stock that should have been sold over Christmas had

become backed up, necessitating sharp price cuts to

shift excess produce. ASOS’s Chief Executive said that:

This discounting had led to a significant increase in

sales, well beyond budgeted levels. As a consequence,

we are bearing the costs associated with very high

sales volumes, but without the gross margin to sup-

port them.

In fact, average gross margin fell from 50% to about

30%. He added that ASOS would have done even bet-

ter than its 70% sales leap over Christmas, had it not

been working out of four dispersed warehouses, when

it needed a centralised strategic site.The difficulties in

coordinating distribution resulted in delays in items

appearing on the ASOS website, causing the backlog of

stock. Happily, he was able to report the appointment

of a new general manager to oversee distribution, and

that ASOS had found a 70,000 sq. ft. warehouse

expected to come into use in three months. This

mixed message probably helped to moderate the

market’s reaction to the profit warning, limiting the

share price fall to 11%.

Source: Based on article by Lisa Urquhart, Financial Times, 4 March 2005.

The book is divided into six parts, each with a full page

introduction and chapter information to help you navigate

around the book.

Topical cameos open each chapter, applying financial

management principles to well-known companies.

Mini-case studies also appear throughout the book.

Learning objectives highlight what you should expect

to achieve from each chapter in terms of concepts,

terminology and skills.

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

Chapter 13 Treasury Management and working capital policy 337

(e) Interest rate options. Also termed interest rate guarantees, these contracts grant the

buyer the right but not the obligation to deal at a specific interest rate at some

future date.

(f) Interest rate ‘swaps’. These occur where a company (usually very large firms) with

predominantly variable rate debt, worried about a rise in rates, ‘swaps’ or match-

es its debt with a company with predominantly fixed-rate debt concerned that

rates may fall. A bank usually acts as intermediary in the process, but it can be

through direct negotiations with another company. Each borrower will still remain

responsible for the original loan obligations incurred. Typically, firms continue to

pay the interest on their own loan and then, at the end of the agreed period, a cash

adjustment will be made between the two parties to the swap agreement. Interest

rate swaps can also involve exchanges in different currencies.

13.7 WORKING CAPITAL MANAGEMENT

The last main area of treasury management is the management of working capital,

including liquidity management. We devote the remainder of this chapter to working

capital policy and the following chapter to short-term asset management. Let us first

clarify the basic terms and ratios employed in working capital management.

Net working capital (or simply working capital) refers to current assets less current

liabilities – hence its alternative name of net current assets. Current assets include

cash, marketable securities, debtors and stock. Current liabilities are obligations that

are expected to be repaid within the year.

Working capital management refers to the financing, investment and control of net

current assets within policy guidelines. The treasurer acts as a steward of corporate

resources and needs to devise and operate clear and effective working capital policies.

Self-assessment activity 13.5

Define in your own words the main forms of derivatives – forwards, futures, swaps and options.

(Answer in Appendix A at the back of the book)

Not everyone likes derivatives

Warren Buffet, the so-called ‘Sage of Omaha’, has an excellent track record in managing

his investment vehicle, Berkshire Hathaway, having outperformed the S&P 500 index in 34

of the past 39 years (up to 2003). His success is based largely on sticking to firms that

produce simple basic products for which there is always likely to be a demand. ‘If you

don’t understand it, don’t invest in it’ is one of his mottos – he is famed for not investing

in technology stocks during the internet boom.

He is also very scathing about the relative freedom of companies and dealers to value

positions in swaps, options and other complex products whose prices are not listed on

exchanges, thus giving a potentially misleading picture of a firm’s true future liabilities.

According to Buffet, derivatives are ‘Weapons of Mass Financial Destruction’, time bombs

waiting to explode in the faces of the parties that deal in them, and for the whole econom-

ic system. Designed as risk management devices, he says they actually pose risks that cen-

tral banks and governments have so far found no effective way to control, or even monitor.

Source: Based on Warren Buffet’s annual letter to shareholders, as reported in an article in the Economist, 15 March 2003.

net working capital

Current assets less current

liabilities

Chapter 2 The financial environment 47

Self-assessment activity 2.8

Explain why it is important to consider the tax implications of financial and investment

decisions.

(Answer in Appendix A at the back of the book)

This chapter has introduced readers to the financial and tax environment within which

financial and investment decisions take place.

Key points

■ Financial markets consist of numerous specialist markets where financial transac-

tions occur (e.g. the money market, capital market, foreign exchange market, deriv-

atives markets).

■ Financial institutions (e.g. banks, building societies, pension funds) provide a vital

service by acting as financial intermediaries between savers and borrowers.

■ Securitisation and disintermediation have permitted larger companies to create

alternative, more flexible forms of finance.

■ The London Stock Exchange operates two tiers: the Main List for larger established

companies, and the Alternative Investment Market which mainly caters for very

young companies.

■ An efficient capital market is one where investors are rational and share prices

reflect all available information. The Efficient Markets Hypothesis has been exam-

ined in its various forms (weak, semi-strong and strong). In all but the strong form,

it seems to hold up reasonably well, but it is increasingly unable to explain ‘special’

circumstances.

■ The problem of ‘short-termism’ may stem more from managerial attitudes than

those of investors.

■ Taxation can play a key role in financial management, particularly in raising

finance, investing in fixed assets and paying dividends.

SUMMARY

Further reading

Brett (2003) provides a clear explanation of how to read the financial pages in the press. Clear

and more extensive introductions to capital markets are found in Foley (1991), and Weston

Copeland (1992), O’Shea (1986) and Redhead (1990).

The Stock Exchange Fact Book is published annually by the Stock Exchange. Two classic review

articles on market efficiency were written by Fama (1970 and 1992), while Rappaport (1987)

examines the implications for managers.Tests of capital market efficiency are found in Copeland

and Weston (2004) and Keane (1983), while some exceptions to efficiency are found in the June

1977 special issue of Journal of Financial Economics. Peters (1991, 1993) applies Chaos Theory

to stock markets. Discussion on short-termism in the City is found in Marsh (1990) and Ball

(1991). Mastering Finance (1997) offers useful articles on securitisation, financial intermediaries,

the role of financial markets, market efficiency and short-termism.

Chapter 7 Investment strategy and process 191

Questions with a coloured number have solutions in Appendix B on page 695.

1 ‘Capital budgeting is simply a matter of selecting the right decision rule.’ How true is this statement?

2 What are the aims of post-audits?

3 AMT plc is increasing the level of automation of a production line dedicated to a single product. The options

available are total automation or partial automation. The company works on a planning horizon of five years

and either option will produce the 10,000 units which can be sold annually.

Total automation will involve a total capital cost of £1 million. Material costs will be £12 per unit and labour

and variable overheads will be £18 per unit with this method.

Partial automation will result in higher material wastage and an average cost of £14 per unit. Labour and

variable overhead are expected to cost £41 per unit. The capital cost of this alternative is £250,000.

The products sell for £75 each, whichever method of production is adopted. The scrap value of the auto-

mated production line, in five years’ time, will be £100,000, while the line which is partially automated will

be worthless. The management uses straight-line depreciation and the required rate of return on capital

investment is 16 per cent p.a. Depreciation is considered to be the only incremental fixed cost.

In analysing investment opportunities of this type the company calculates the average total cost per unit,

annual net profit, the break-even volume per year and the discounted net present value.

Required

(a) Determine the figures which would be circulated to the management of AMT plc in order to assist their

investment analysis.

(b) Comment on the figures produced and make a recommendation with any qualifications you think appro-

priate.

(Certified Diploma)

4 Bowers Holdings plc has recently acquired a controlling interest in Shaldon Engineering plc, which produces

high-quality machine tools for the European market. Following this acquisition, the internal audit department

of Bowers Holdings plc examined the financial management systems of the newly acquired company and pro-

duced a report that was critical of its investment appraisal procedures.

The report summary stated:

Overall, investment appraisal procedures in Shaldon Engineering plc are very weak. Evaluation of capital

projects is not undertaken in a systematic manner and post-decision controls relating to capital projects are

virtually non-existent.

Required

Prepare a report for the directors of Shaldon Engineering plc, stating what you consider to be the major

characteristics of a system for evaluating, monitoring and controlling capital expenditure projects.

(Certified Diploma)

What procedures should a business adopt for approving and reviewing large capital expenditure projects?

QUESTIONS

Read the Harvard Business Review article (Sept.–Oct. 1989) ‘Must finance and strategy clash?’ by Barwise, Marsh

and Wensley. Summarise and comment on their views on the question.

Practical assignment

Topical articles on real-world examples taken from the financial

press, including the

Financial Times

, bring the subject to life.

Self-assessment activities reinforce points made in the text, and

encourage self-learning. Answers are found in Appendix A at the

back of the book.

Key terms are highlighted in the text where they first appear,

with definitions in the margin. The full glossary also appears in the

back of the book and on the Student Companion Website at

www.pearsoned.co.uk/pikeneale.

Summaries and Key points appear at the end of each

chapter to give a reminder of main concepts covered.

Further reading suggestions are made to enable topics to

be studied in more depth.

Questions at the end of each chapter test a mix of numerical,

analytical and descriptive skills. Many of the questions are taken from

the examination papers of professional bodies such as CIMA and

ACCA. Selected answers can be found in Appendix B at the back of

the book.

Practical assignments consider the application of concepts to a

company, organisation or published report.

Additional Quests can be found on the Student Companion Website

www.pearsoned.co.uk/pikeneale, providing the opportunity to

seek out information and apply what you have learnt.

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

A Summary for each chapter can be found on

the Student Companion Website at

www.pearsoned.com/pikeneale, to give a

reminder of the main points covered.

For each chapter there are Multiple Choice,

True/False and Fill-in-the-blank Questions,

giving you the chance to check your progress

and get instant feedback.

Useful Websites are listed at

the end of each chapter, and

Weblinks to these sites are

provided on the Student

Companion Website.

Guided tour of the website

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

Acknowledgements

All textbooks include ‘acknowledgements’ but, on reflection, this seems too weak a

word to use when assistance has so often been so freely given. Roget’s Thesaurus

offers as a synonym, ‘the act of admitting to something’, suggesting rather grudging

recognition!

Our recognition of the wide range of people and organizations is anything but

grudging. We extend our warm appreciation of the helpful comments provided by

you over the years, and also for consent to use your material.

To the ever-lengthening roll of honour, we wish to add the following names and

organizations, whom we sincerely hope will be happy to be associated with our efforts:

Andrew Barfield

Maxim Kakareka

Professor Colin Mason – University of Strathclyde

Professor Andrew Marshall, University of Strathclyde

Sue Lane

Peter Blankenhorn – E.On AG

Andrew Naughton-Doe – Corus UK plc

Pat Rowham – LBS

Peter Aubusson – DS Smith plc

Sue Cox – BAA plc

ASJR Ramsay – International Power plc

“Sarah” at British Airways plc

Jane Lanyon – Thorntons plc

Ian Lomas – DTI

Ian Patterson – HM Customs & Excise

As ever, we apologise for any omissions.

Finally, we are especially grateful to the ever-patient, ever-tolerant editorial staff at

Pearson Education, and to the anonymous contributors to the market research

conducted by the publisher. We hope that you will agree that your comments have led

to an improvement in the quality of the final product. Naturally, as ever, we claim sole

responsibility for any remaining errors.

Richard Pike, University of Bradford

Bill Neale, Bournemouth University

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

Publisher’s Acknowledgements

We are grateful to the Financial Times Limited for permission to reprint the following material:

A manager’s real responsibility, © Financial Times, 30 January 2002; Inion plans £30m public

offering, © Financial Times, 10 November 2004; Table 2.2 Table of food retail sector share prices,

Capturing the indefinable value of a brand, © Financial Times, 9 February 2005; The Japanese art

of performance, © Financial Times, 18 May 2004; Nalco plans $2 billion smelter in Qatar,

with Boeing, © Financial Times, 17 January 2005; Lex live: Metro and the weather, FT.com,

March 2003; Shareholders want their cash handed back to them, © Financial Times, 15 September

2004; BMW bets on rebound for falling US dollar, © Financial Times, 18 March 2004; Table 21.4

Table of share prices, © Financial Times, 4 January 2005; Lex: Deutsche Telekom, © Financial Times,

12 November 2004; Sistema in record $1.3bn flotation, © Financial Times, 10 February 2005; Coral

Eurobet makes £400m capital return, © Financial Times, 1 December 2004; Boots to generate

£300m in sale and leaseback, © Financial Times, 25 January 2005; Vodaphone doubles its dividend

pay-out, © Financial Times, 17 November 2004; Rosy view of share buybacks ignores paucity of

investment opportunities, © Financial Times, 11 and 12 September 2004; Cable and wireless,

Times, 23 November 2004; BA to raise £435m in sale of Qantas stake, FT.com, © Financial Times, 8

September 2004; News Corp unveils poison pill defence strategy, © Financial Times, 9 November

2004; Acquisitions in US ‘disastrous’ for British companies, © Financial Times, 11 October 2004;

IPO revival helps buy-outs to four-year high, © Financial Times, 4 January 2005; Investors show

various traits of behaviour, © Financial Times, 27 March 2004.

We are grateful to the following for permission to use copyright material:

Corus plc for permission to use an extract from their 2004 Annual Report; DS Smith plc for

permission to use an extract from their 2004 Annual Report and Accounts; The Economist

Newspaper Limited for the article ‘Investing in Indonesia: At a crossroads’ published in The

Economist 8

May 2004 © The Economist Newspaper Limited, London, 2004; Tomkins plc for an

extract from Tomkins plc Reports and Accounts 2003; New risks put scenario planning in favour

from Financial Times Limited, 19 August 2003, © Awi Federgruen and Garrett Van Ryzin; Watch

the herd, but don’t join it from The Financial Times Limited, 3 July 2004, © Brian Bloch; Powering

ahead is from a circular sent to International Power shareholders, August 2004, reproduced by

permission of International Power plc; Figure 10.1 from Pilkington plc Director’s Report &

Accounts 2004 reproduced by permission; Figure 10.4 from Financial Reform and Institutions,

Pozna´n University of Economics, T. Kowalski and S. Letza (eds), T. Short (2000). Reproduced by

permission of the editors; Table 18.1 from the BAA plc Annual Report for the year ending 31

March 2004, with permission from BAA; Figure 22.1 Reprinted from European Management

Journal, Vol 22, No 1, Grant, R., & Soenen, L., Strategic Management of Operating Exposure, pp.

In some instances we have been unable to trace the owners of copyright material, and we would

appreciate any information that would enable us to do so.

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

FORMULAE, EQUATIONS AND DEFINITIONS

DEFINITIONS

value of debt

of earnings retained by a firm

geared

or activity Beta for company

ungeared

covariance of returns on the shares of companies and

covariance of returns on the shares of companies and the return on the market portfolio.

per share at time zero

in year t, equal to free cash flow if expressed net of replacement investment

return on the shares of company

return on the market portfolio

return on a specified portfolio

rate of exchange for delivery in one period’s time

value

rate of growth in dividends and

of interest

rate of inflation

rate of return

of debt

of return required by shareholders

Average Cost of Capital (WACC) (overall cost of capital)

or nominal, required return (also used to denote the market portfolio)

deviation of the return on company j’s shares

of the return on company j’s shares

deviation of the return on the market portfolio

deviation of the return on a specified portfolio

P:E Ratio

price at time zero

value interest factor for single payment at i% after n years

value interest factor for an annuity at i% for n years

on re-invested earnings, also used for real cost of capital

of return on a risk-free asset

Shareholder Return for company in time period

return on the market portfolio

return on a specified portfolio

coefficient between the returns on the shares of company i and company j respectively.

coefficient between the returns on the shares of company j and the return on the market portfolio.

spot rate of exchange

spot rate of exchange in time period 1.

of tax on corporate profits, or

of tax on personal income

Value of debt (borrowings)

of a geared firm

of whole firm at time

Value of Shares

of an ungeared of equity in the firm

Cash Inflow in year t.X

 Net

firm  valueV

 Value

 Market

zero  enterprise valueV

 Value

 Market

TB  Tax Shield

 rate

T  rate

 expected

 today’s

 the correlation

 actual

 Total

 rate

R  rate of return

PVIFA

1i,n2

 present

PVIF

1i,n2

 present

 share

1PER2  1Profit After Tax>Earnings per Share2

 standard

 variance

 standard

M  money,

 Weighted

 rate

 cost

k  required

I  expected

i  rate

earnings  1b  R2g  annual

FV  future

 forward

EV  expected value

 expected

1 k

2ER

 required

 earnings

 dividend

Cov

, or s

,  the

Cov

, or s

,  the

 Beta

 asset

 Beta

b  proportion

B  book

CFAI_A02.QXD 10/28/05 2:14 PM Page 2

Business financial decisions are not made in a vacuum. An ‘obvious’ decision may often have to be

tempered by an appreciation of the restrictions imposed by the prevailing environment. Although it

is beyond our scope to consider the full social, political and economic complexity of the financial

decision-making context, we provide an overview of the key features of the UK financial and

economic system. A sound grasp of the framework for financial decisions is essential if the reader is

to appreciate fully the issues discussed in subsequent chapters of this book.

Part I provides an introduction to the scope and the fundamental concepts of financial manage-

ment, Chapter 1 provides a broad picture of the subject and the important role it plays in business.

It examines the nature of financing and investment decisions, the role of the financial manager and

the fundamental objective for corporate financial management. This leads on, in Chapter 2, to

consideration of the financial and tax environment in which businesses operate. Particular attention

is devoted to the characteristics and operation of the London Stock Exchange, which provides a

barometer of the success of financial decisions via the market’s valuation of the company’s shares.

The extent to which any market can provide ‘accurate’ valuations is also considered.

Central concepts in financial management are the time-value of money and present value, which are

discussed in Chapter 3. These ideas are developed in Chapter 4 to provide an understanding of

valuation. Concepts of value and its measurement play important roles in subsequent chapters,

where investment, financing and other key decisions are discussed.

Chapter 1 An overview of financial management 3

Chapter 2 The financial environment 24

Chapter 3 Present values and financial arithmetic 38

Chapter 4 Valuation of assets, shares and companies 66

A FRAMEWORK FOR

FINANCIAL DECISIONS

Part

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CFAI_C01.QXD 3/15/07 7:23 AM Page 2

An overview of financial management

Learning objectives

By the end of this chapter, you should understand the following:

■ What corporate finance and investment decisions involve.

■ How financial management has evolved.

■ The finance function and how it relates to its wider environment and to strategic planning.

■ The central role of cash in business.

■ The goal of shareholder wealth creation and how investors can encourage managers to adopt

this goal.

■ The underlying principles of finance.

Working for shareholders

Tomkins plc, the international engineering and manufacturing group, has enjoyed one of the fastest growth

rates over the past thirty years. What are the main objectives for such a company? The chairman, in his state-

ment on the 2003 accounts, makes it clear:

‘Our principal objective must be to achieve long term sustainable growth in the economic value of

Tomkins through strategic development of our businesses. Through effective communication to the finan-

cial markets, this translates into growth in equity value for our shareholders.’

Source: Tomkins plc Report & Accounts, 2003.

CFAI_C01.QXD 3/15/07 7:23 AM Page 3

4 Part I A framework for financial decisions

1.1 INTRODUCTION

The Tomkins plc mission statement, summarised at the start, suggests that its manage-

ment has a clear idea of its purpose and key objectives. Its mission is to deliver eco-

nomic value to its shareholders in the form of dividend and capital growth. An

organisation such as Tomkins, with a broad range of products, understands the impor-

tance of meeting the requirements of its existing and potential customers. But it also

recognises that the most important ‘customers’ are the shareholders – the owners of the

business. Its objectives, strategies and decisions are all directed towards creating value

for them.

One of the challenges in any business is to make investments that consistently yield

rates of return to shareholders in excess of the cost of financing those projects and bet-

ter than the competition. This book centres on that very issue: how can firms create value

through sound investment decisions and financial strategies?

This chapter provides a broad picture of financial management and the fundamen-

tal role it plays in achieving financial objectives and operating successful businesses.

First, we consider where financial management fits into the strategic planning process

for a new business. This leads to an outline of the finance function and the role of the

financial manager, and what objectives he or she may follow. Central to the subject is

the nature of these financial objectives and how they affect shareholders’ interests.

Finally, we introduce the underlying principles of finance, that are developed in later

chapters.

■ Starting a business: Brownbake Ltd

Ken Brown, a recent business graduate, decides to set up his own small bakery busi-

ness. He recognises that a clear business strategy is required, giving a broad thrust to

be adopted in achieving his objectives. The main issues are market identification, com-

petitor analysis and business formation. He identifies a suitable market with room for

a new entrant and develops a range of bakery products that are expected to stand up

well, in terms of price and quality, against the existing competition.

Brown and his wife become the directors of a newly formed limited company,

Brownbake Ltd. This form of organisation has a number of advantages not found in a

sole proprietorship or partnership:

■ Limited liability. The financial liability of the owners is limited to the amount they

have paid in. Should the company become insolvent, those with outstanding claims

on the company cannot compel the owners to pay in further capital.

■ Transferability of ownership. It is generally easier to sell shares in a company, particu-

larly if it is listed on a stock market, than to sell all or part of a partnership or sole

proprietorship.

■ Permanence. A company has a legal identity quite separate from its owners. Its exis-

tence is unaffected by the sale of shares or death of a shareholder.

■ Access to markets. The above benefits, together with the fact that companies enable

large numbers of shareholders to participate, mean that companies can enjoy finan-

cial economies of scale, giving rise to greater choice and lower costs of financing the

business.

Brown should have a clear idea of why the business exists and its financial and

other objectives. He must now concentrate on how the business strategy is to be imple-

mented. This requires careful planning of the decisions to be taken and their effect on

the business. Planning requires answers to some important questions. What resources

are required? Does the business require premises, equipment, vehicles and material to

produce and deliver the product?

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