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Dr Ann Butchers, Senior Teaching Fellow, University of Warwick, UK In these turbulent financial and economic times make sure the future of good business practice and sound investment decisions lies in your own hands. Understand the importance of the financial decision-making process in business today with the new sixth edition of this popular and well-established text book. From classic cases of ownership versus control of a firm, to more recent events affecting the methods and financial instruments used by companies to raise finance, Corporate Finance and Investment develops, explains and above all applies key concepts and techniques in finance to a broad range of contemporary management and business policy concerns and challenges. MyFinanceLab Classic features: • A strategic focus • A practical approach • A clear and accessible style • An international perspective Take a look below to see what’s new: • New chapter 12 Enterprise Value and Equity Value • New greater focus on derivatives and interest rate management in chapter 13 • New section on Islamic Finance in chapter 16 • New section on private equity in chapter 20 • New detailed worked examples in every chapter • New and improved further reading guides, which focus on key empirical references, at the end of every chapter. • New news articles in every chapter illustrate how theory is being used in practice. • New statistics, figures, charts and tables have been successfully updated to reflect the latest data. A brand new online learning resource for this edition available to users of this book, www.myfinancelab.com An unrivalled online study and testing resource that generates a personalised study plan and provides extensive practice questions exactly where you need it. Also available on the site: • Podcasts relate finance theory to topical issues recently documented in the news • Videos relating to each part of the book give you the opportunity to watch interviews with Managing Directors and Finance Directors of global companies to see how they run their business. • Audio animations guide you step-by-step through the key concepts in corporate finance. See the first page of this text for information on how to register and start using the resources 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. Recommended by CIMA and ACCA it is particularly suitable for those aiming for professional body qualifications, e.g., from CIMA, ACCA, or ICAS Richard Pike is a Chartered Accountant and Professor of Finance at the Bradford University School of Management. Bill Neale is a freelance lecturer and writer, formerly of University of Bournemouth Institute of Business & Law. He is co–author, with Trefor McElroy, of the Pearson Education text Business Finance: A Value-Based Approach. an imprint of CVR_PIKE5504_06_SE_CVR.indd 1 Front cover image: © Getty Images Sixth Edition Corporate Finance and Investment Decisions and Strategies “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.” Sixth Edition Corporate Finance and Investment Decisions and Strategies Richard Pike and Bill Neale Pike Neale www.pearson-books.com 3/11/08 10:26:45 A01_PIKE5504_06_SE_FM.QXD 10/29/08 3:35 PM Page i CORPORATE FINANCE AND INVESTMENT The Power of Practice With your purchase of a new copy of this textbook, you received a Student Access Kit for MyFinanceLab for Corporate Finance and Investment, sixth edition. Follow the instructions on the card to register successfully and start making the most of the resources. Don’t throw it away! The Power of Practice: MyFinanceLab is an online study and testing resource that puts you in control of your study, providing extensive practice exactly where and when you need it. MyFinanceLab gives you unrivalled resources: ■ Sample tests for each chapter allowing you to see how much you have learned and where you still need practice ■ A personalised study plan, which constantly adapts to your strengths and weaknesses taking you to exercises you can practice over and again with different variables every time ■ Guided solutions which break the problem into its component steps and guide you through with hints ■ Audio animations to guide you step by step through the key concepts in corporate finance. ■ Podcasts analysing topical issues and recent news items in finance. ■ Video clips of CEOs and Financial Directors from large companies explaining how they make financial decisions for each part of the book. ■ E text ■ Online glossary which defines key terms and provides examples See Using MyFinanceLab on page xxii for more details. To activate your registration go to www.myfinancelab.com/register and follow the instructions on screen to register as a new user. A01_PIKE5504_06_SE_FM.QXD 10/29/08 3:35 PM Page ii We work with leading authors to develop the strongest educational materials in finance, bringing cutting-edge thinking and best learning practice to a global market. Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications which help readers to understand and apply their content, whether studying or at work. To find out more about the complete range of our publishing, please visit us on the World Wide Web at: www.pearsoned.com A01_PIKE5504_06_SE_FM.QXD 10/29/08 3:35 PM Page iii CORPORATE FINANCE AND INVESTMENT DECISIONS & STRATEGIES Sixth Edition Richard Pike and Bill Neale A01_PIKE5504_06_SE_FM.QXD 10/31/08 10:07 AM Page iv To our wives, Carol and Jean Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.com First published 1993 Sixth edition published 2009 © Prentice Hall Europe 1993, 1999 © Pearson Education Limited 2003, 2009 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, Saffron House, 6–10 Kirby Street, London EC1N 8TS ISBN 978-0-273-71550-4 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 Pike, Richard (Richard H.) Corporate finance and investment : decisions & strategies/Richard Pike and Bill Neale. — 6th ed. p. cm. ISBN 978-0-273-71550-4 (pbk.) 1. Corporations—Great Britain—Finance. 2. Investments—Great Britain. 3. Corporations—Europe—Finance. I. Neale, Bill. II. Title. HG4135.P35 2009 658.150941—dc22 2008039373 10 9 8 7 6 5 4 3 2 1 13 12 11 10 09 Typeset in 9.5/12 Palatino by 73. Printed and bound by Rotolito Lombarda, Italy. The publisher’s policy is to use paper manufactured from sustainable forests. A01_PIKE5504_06_SE_FM.QXD 10/29/08 3:35 PM Page v Brief Contents List of figures and tables Preface Guided tour Using MyFinanceLab Acknowledgements Publisher’s acknowledgements xii xiv xviii xx xxii xxiii Part I A FRAMEWORK FOR FINANCIAL DECISIONS 1 An overview of financial management 2 The financial environment 3 Present values, and bond and share valuation 3 23 53 Part II INVESTMENT DECISIONS AND STRATEGIES 81 4 Investment appraisal methods 5 Project appraisal – applications 6 Investment strategy and process 1 83 113 139 Part III VALUE, RISK AND THE REQUIRED RETURN 7 Analysing investment risk 8 Identifying and valuing options 9 Relationships between investments: portfolio theory 10 Setting the risk premium: the Capital Asset Pricing Model 11 The required rate of return on investment 12 Enterprise value and equity value 157 Part IV SHORT-TERM FINANCING AND POLICIES 13 Treasury management and working capital policy 14 Short-term asset management 15 Short- and medium-term finance 315 Part V STRATEGIC FINANCIAL DECISIONS 16 Long-term finance 17 Returning value to shareholders: the dividend decision 18 Capital structure and the required return 19 Does capital structure really matter? 20 Acquisitions and restructuring 409 Part VI INTERNATIONAL FINANCIAL MANAGEMENT 21 Managing currency risk 22 Foreign investment decisions 613 23 Key issues in modern finance: a review 692 Appendix A Appendix B Appendix C Appendix D 711 729 761 763 Glossary References Index Solutions to self-assessment activities Solutions to selected questions Present value interest factor (PVIF) Present value interest factor for an annuity (PVIFA) 159 184 209 227 262 284 317 349 376 411 453 485 520 550 615 656 765 774 784 A01_PIKE5504_06_SE_FM.QXD 10/29/08 3:35 PM Page vi A01_PIKE5504_06_SE_FM.QXD 10/29/08 3:35 PM Page vii Contents List of figures and tables Preface Guided tour Using MyFinanceLab Acknowledgements Publisher’s acknowledgements xii xiv xviii xx xxii xxiii Part I A FRAMEWORK FOR FINANCIAL DECISIONS Chapter 1 An overview of financial management 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 Introduction The finance function Investment and financial decisions Cash – the lifeblood of the business The emergence of financial management The finance department in the firm The financial objective The agency problem Managing the agency problem Social responsibility and shareholder wealth The corporate governance debate The risk dimension The strategic dimension 3 4 5 6 7 8 9 10 11 12 13 14 16 17 Summary Key points Further reading Questions 19 19 20 21 Chapter 2 The financial environment 23 2.1 2.2 2.3 2.4 2.5 2.6 2.7 24 24 26 30 33 38 40 Introduction Financial markets The financial services sector The London Stock Exchange (LSE) Are financial markets efficient? Reading the financial pages Taxation and financial decisions Summary Key points Further reading Appendix: Financial statement analysis Questions 40 40 41 41 50 Chapter 3 Present values, and bond and share valuation 53 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 54 54 55 56 57 61 64 67 69 Introduction Measuring wealth Time-value of money Financial arithmetic for capital growth Present value Present value arithmetic Valuing bonds Valuing shares: the dividend valuation model Problems with the dividend growth model Summary Key points Further reading Appendix I: The term structure of interest rates and the yield curve Appendix II: Present value formulae Appendix III: The P:E ratio and the constant dividend valuation model Questions 72 72 73 73 75 76 78 Part II INVESTMENT DECISIONS AND STRATEGIES Chapter 4 Investment appraisal methods 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 Introduction Cash flow analysis Net present value Investment techniques – net present value Internal rate of return Profitability index Payback period Accounting rate of return Ranking mutually exclusive projects Investment evaluation and capital rationing Summary Key points Further reading Appendix I: Modified IRR Appendix II: Multi-period capital rationing and mathematical programming Questions 83 84 84 85 89 90 93 94 95 96 100 103 104 104 104 106 110 A01_PIKE5504_06_SE_FM.QXD viii 10/29/08 3:35 PM Page viii Contents Chapter 5 Project appraisal – applications 113 5.1 5.2 5.3 5.4 5.5 5.6 5.7 114 114 117 119 120 123 125 Introduction Incremental cash flow analysis Replacement decisions Inflation cannot be ignored Taxation is a cash flow Use of DCF techniques Traditional appraisal methods Summary Key points Further reading Appendix: The problem of unequal lives: Allis plc Questions 129 129 129 130 132 Chapter 6 Investment strategy and process 139 6.1 6.2 6.3 6.4 6.5 6.6 Introduction Strategic considerations Advanced manufacturing technology (AMT) investment Environmental aspects of investment The capital investment process Post-auditing Summary Key points Further reading Questions 140 140 143 146 147 153 155 155 155 156 Part III VALUE, RISK AND THE REQUIRED RETURN Chapter 7 Analysing investment risk 7.1 7.2 159 Introduction Expected net present value (ENPV): Betterway plc Attitudes to risk The many types of risk Measurement of risk Risk description techniques Adjusting the NPV formula for risk Risk analysis in practice 161 161 163 164 168 172 174 Summary Key points Further reading Appendix: Multi-period cash flows and risk Questions 176 176 176 176 180 7.3 7.4 7.5 7.6 7.7 7.8 160 Chapter 8 Identifying and valuing options 8.1 8.2 8.3 8.4 8.5 8.6 Introduction Share options Option pricing Application of option theory to corporate finance Capital investment options Why conventional NPV may not tell the whole story 184 185 185 193 199 200 204 Summary Key points Further reading Appendix: Black–Scholes option pricing formula Questions 205 205 205 206 207 Chapter 9 Relationships between investments: portfolio theory 209 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 Introduction Portfolio analysis: the basic principles How to measure portfolio risk Portfolio analysis where risk and return differ Different degrees of correlation Worked example: Gerrybild plc Portfolios with more than two components Can we use this for project appraisal? Some reservations 210 211 212 215 217 218 221 222 Summary Key points Further reading Questions 224 224 224 225 Chapter 10 Setting the risk premium: the Capital Asset Pricing Model 227 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 Introduction Security valuation and discount rates Concepts of risk and return The relationship between different equity markets Systematic risk Completing the model Using the CAPM: assessing the required return Worked example The underpinnings of the CAPM Portfolios with many components: the capital market line 228 228 229 232 234 238 239 244 245 246 A01_PIKE5504_06_SE_FM.QXD 10/29/08 3:35 PM Page ix Contents 10.11 10.12 10.13 10.14 10.15 10.16 10.17 How it all fits together: the key relationships Reservations about the CAPM Testing the CAPM Factor models The Arbitrage Pricing Theory Fama and French’s three-factor model Issues raised by the CAPM: some food for managerial thought 248 250 250 252 253 254 255 Summary Key points Further reading Appendix: Analysis of variance Questions 257 257 258 258 260 Chapter 11 The required rate of return on investment 262 11.1 Introduction 11.2 The required return in all-equity firms: the DGM 11.3 The required return in all-equity firms: the CAPM 11.4 Using ‘tailored’ discount rates 11.5 Worked example: Tieko plc 11.6 Another problem: taxation and the CAPM 11.7 Problems with ‘tailored’ discount rates 11.8 A critique of divisional hurdle rates 263 267 269 274 276 277 278 Summary Key points Further reading Questions 279 279 280 281 263 Chapter 12 Enterprise value and equity value 284 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 12.10 12.11 12.12 285 285 286 292 294 294 296 300 301 302 303 306 Introduction The valuation problem Valuation using published accounts Valuing the earnings stream: P:E ratios EBITDA – a halfway house Valuing cash flows The DCF approach Valuation of unquoted companies Shareholder value analysis Using value drivers Worked example: Safa plc Economic value added (EVA) Summary Key points Further reading Questions 307 308 308 309 ix Part IV SHORT-TERM FINANCING AND POLICIES Chapter 13 Treasury management and working capital policy 317 13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 13.9 13.10 13.11 318 318 320 322 324 324 334 336 337 338 342 Introduction The treasury function Funding How firms can use the yield curve Banking relationships Risk management Working capital management Predicting corporate failure Cash operating cycle Working capital policy Overtrading problems Summary Key points Further reading and website Questions 343 343 344 345 Chapter 14 Short-term asset management 349 14.1 14.2 14.3 14.4 14.5 14.6 350 350 358 363 366 368 Introduction Managing trade credit Inventory management Cash management Worked example: Mangle Ltd Cash management models Summary Key points Further reading Appendix: Miller–Orr cash management model Questions 369 369 370 370 372 Chapter 15 Short- and medium-term finance 376 15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 15.9 15.10 Introduction Trade credit Bank credit facilities Invoice finance (or ‘asset-based finance’) Using the money market: bill finance Hire purchase (HP) Leasing Lease evaluation: a simple case Motives for leasing Allowing for Corporation Tax in lease evaluation 377 377 379 382 384 386 388 390 393 395