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(BQ) Part 2 book Corporate finance and investment has contents Treasury management and working capital policy, shortterm asset management, short and mediumterm finance, longterm finance, capital structure and the required return, capital structure and the required return, foreign investment decisions,...and other contents.
CFAI_C13.QXD 10/26/05 11:41 AM Page 321 www.downloadslide.com Part IV SHORT-TERM FINANCING AND POLICIES The acquisition of every asset has to be financed Companies obtain two forms of finance, short and long term, although, in practice, it is difficult to make a rigid demarcation between them Part IV is devoted to analysing short-term financing, while the analysis of long-term financing decisions appears in Part V Chapter 13 offers an overview of the financing operations of the modern corporation, focusing on balancing the inflows and outflows of funds in the process of treasury management The chapter examines the importance of working capital management, and how the financial manager may use the derivatives markets Chapter 14 looks at managing short-term assets – cash, stocks, debtors – and the financing implications of different working capital policies Chapter 15 describes the various forms of short(and medium-) term sources of finance, especially trade credit and the banking system, and also discusses the analysis of leasing decisions and the finance of foreign trade Chapter 13 Treasury management and working capital policy Chapter 14 Short-term asset management Chapter 15 Short- and medium-term finance 353 379 321 CFAI_C13.QXD 10/26/05 11:41 AM Page 322 www.downloadslide.com CFAI_C13.QXD 10/26/05 11:41 AM Page 323 www.downloadslide.com 13 Treasury Management and working capital policy Treasury Management at DS Smith plc The Group treasury strategy is controlled through a Treasury Committee, which meets regularly and includes the Chairman, the Group Chief Executive and the Group Finance Director The Group Treasury function operates in accordance with documented policies and procedures approved by the Board and controlled by the Group Treasurer The function arranges funding for the Group, provides a service to operations and implements strategies for interest rate and foreign exchange exposure management The major treasury risks to which the Group is exposed relate to movements in interest rates and currencies The overall objective of the Treasury function is to control these exposures whilst striking an appropriate balance between minimising risks and costs Financial instruments and derivatives may be used in implementing hedging strategies, but no speculative use of derivatives or other instruments is permitted The Treasury Committee regularly reviews the Group’s exposure to interest rates and considers whether to borrow on fixed or floating terms For the last few years the Group has generally chosen to borrow on floating rates, which the Committee believes have provided better value During the year, however, the Group took advantage of the historically low level of medium to long-term sterling interest rates and fixed the interest rate on £40 million of sterling denominated borrowings for a period of five years at an average rate (before margin) of just under 4% Group policy is to hedge the net assets of major overseas subsidiaries by means of borrowings in the same currency to a level determined by the Treasury Committee The borrowings in currency give rise to exchange differences on translation into sterling, which are taken to reserves A portion of the Group’s net borrowings are denominated in euros, which are held to hedge the underlying assets of our eurozone operations At the year end, these borrowings represented 64% of our eurozone net assets Reprinted with permission, DS Smith plc, Annual Report and Accounts, 2004 Learning objectives Treasury management and working capital policy are central to the whole of corporate finance After reading this chapter, you should appreciate the following: ■ The purpose and structure of the treasury function ■ Treasury funding issues ■ How to manage banking relationships ■ Risk management, hedging and the use of derivatives ■ Working capital policies ■ The cash operating cycle and overtrading problems CFAI_C13.QXD 10/26/05 11:41 AM Page 324 www.downloadslide.com 324 Part IV Short-term financing and policies 13.1 INTRODUCTION The introductory case study gives a flavour of the work of the Treasury in a large modern organisation (DS Smith is a leading packaging manufacturer) It also identifies some of the areas where things can potentially go wrong Treasury management, once viewed as a peripheral activity conducted by backoffice boffins, today plays a vital role in corporate management Most business decisions have implications for cash flow and risk, both of which are of direct relevance to treasury management Many major firms have experienced problems through poor treasury management in recent years This area has become a major concern in business, particularly the manner in which companies manage exposure to currency and other risks Most companies not have a corporate treasurer; such a person is usually warranted only in larger companies However, all firms are involved in treasury management to some degree Treasury management can be defined in many ways We will adopt the Association of Corporate Treasurers definition: ‘the efficient management of liquidity and financial risk in the business’ This chapter seeks to explain the main functions of treasury management and to provide an overview of working capital management It also acts as an introduction to many of the succeeding chapters in this book 13.2 THE TREASURY FUNCTION The size, structure and responsibilities of the treasury function will vary greatly among organisations Key factors will be corporate size, listing status, degree of international business and attitude to risk For example, BP plc is a major multinational company with a strong emphasis on value creation, where currency and oil price movements can have a dramatic impact on corporate earnings It is not surprising that it has a highly developed group treasury function, covering the following: Global dealing – foreign exchange, interest rate management, short-term borrowing, short-term deposits Treasury services – cash management systems, transactional banking Corporate finance – capital markets, banking relationships, trade finance, risk management, liability management M&A equity management – mergers and acquisitions, equity markets, investor relations and divestitures (from The Treasurer, February 1992) funding Cash and liquidity management, short-term financing and cash forecasting treasury operations Financial risk management, and portfolio management In most companies, the treasury department is much simpler, typically with a distinction between funding (cash and liquidity management, short-term financing and cash forecasting) and treasury operations (financial risk management and portfolio management) Treasury departments have come under increasing scrutiny by the financial press Barely a month passes without some large company announcing hefty losses resulting from some major blunder by its treasury department In the highly complex, highly volatile world of finance, there are bound to be mistakes; the secret is to set up the treasury function such that mistakes are never catastrophic It is the responsibility of the board of directors to set the treasury aims, policies, authorisation levels, risk position and structure It should establish, for example, the following: ■ ■ ■ ■ The degree of treasury centralisation Whether it should be a profit centre or cost centre The extent to which the company should be exposed to financial risk The level of liquidity desired CFAI_C13.QXD 10/26/05 11:42 AM Page 325 www.downloadslide.com Chapter 13 Treasury Management and working capital policy 325 UK TREASURER International Consumer Products Group West London ■ ■ ■ ■ ■ ■ UK headquartered consumer products group with wide range of household name brands Turnover exceeds £3 billion from some 40 countries Will be a member of a small team reporting to the Group Treasurer and will have responsibility for all banking, supported by a team of two Principal activities will cover the dealing area; cash management systems and liaison with the Group’s bankers; interest risk management, both forex and interest rate; and ad hoc projects including overseas banking reviews Graduate, part or fully qualified ACT with hands-on dealing room experience Background is likely to be within a substantial international group An accountancy qualification would be advantageous Excellent communicator, able to quickly establish credibility and develop sound working relationships across the business A team-worker with flexibility of approach, committed to technical excellence This is a first-class opportunity within a group which has an excellent reputation for its pro-active approach to treasury management A typical job advertisement in the press We pick up the last two points later, but deal with the structural issues in the following sections ■ Degree of centralisation Even in the most highly decentralised companies, it is common to find a centralised treasury function The advantages of centralisation are self-evident: The treasurer sees the total picture for cash, borrowings and currencies and is therefore able to influence and control financial movements on a global basis to achieve maximum after-tax benefit The gains from centralised cash management can be considerable Centralisation helps the company develop greater expertise and more rapid knowledge transfer It permits the treasurer to capture any benefits of scale Dealing with financial and currency markets on a group basis not only saves unnecessary duplication of effort, but should also reduce the cost of funds The major benefits from decentralising certain treasury activities are: ■ ■ ■ By delegating financial activities to the same degree as other business activities, the business unit becomes responsible for all operations Divisional managers in centralised treasury organisations are understandably annoyed at being assessed on profit after financing costs, over which they have little direct control It encourages management to take advantage of local financing opportunities of which group treasury may not be aware and be more receptive to the needs of each division Profit centres and cost centres In many large multinational firms, there is a substantial flow of cash each year in both domestic and foreign currencies The volumes involved offer the opportunity to speculate, CFAI_C13.QXD 10/26/05 11:42 AM Page 326 www.downloadslide.com 326 Part IV Short-term financing and policies especially if the more favourable interest rates and exchange rates are available Moreover, such firms probably employ staff skilled in cash and foreign exchange management techniques and may decide to use these resources pro-actively, i.e to make a profit profit centre treasury In a profit centre Treasury (PCT), staff are authorised to take speculative positions, (PCT) usually within clearly specified limits, by trading financial instruments in the same way A corporate treasury that aims as a bank Such ‘in-house banks’ are judged on their return on capital achieved, although to makes a profit from its dealing – managers are judged it is difficult to arrive at an accurate measure of capital employed The main problem on profit performance with operating a profit centre is that traders may exceed their permitted positions, either through negligence or in pursuit of personal gain (See the Barings case on page 333.) Conversely, a cost centre Treasury (CCT) aims at operating as efficiently as possible, cost centre treasury (CCT) A treasury that aims to minand eliminates risks as soon as they arise DS Smith, the firm in the introductory case, imise the cost of its dealings clearly operates a CCT, i.e it hedges rather than speculates, as a matter of policy JP Morgan Fleming conducts an annual survey of cash and treasury management practices, in conjunction with the ACT In 2003, it found that 82 per cent of its 347 respondents considered their treasury function to be a cost centre (aiming ‘to manage the exposure providing value-added solutions that not increase the risk of the company’), while 18 per cent considered their Treasury to be a profit centre (aiming ‘to take active balance sheet risks to enhance returns’) Self-assessment activity 13.1 How would you define treasury management? (Answer in Appendix A at the back of the book) Let us now examine the four pillars of treasury management: funding, banking relationships, risk management, and liquidity and working capital 13.3 FUNDING Corporate finance managers must address the funding issues of: (1) how much should the firm raise this year, and (2) in what form? We devote two later chapters to these questions, examining long-, medium- and short-term funding For the present, we simply raise the questions that subsequent chapters will pursue in greater depth Why firms prefer internally generated funds? Internally generated funds, defined as profits after tax plus depreciation, represent easily the major part of corporate funds In many ways, it is the most convenient source of finance One could say it is equivalent to a compulsory share issue, because the alternative is to pay it all back to shareholders and then raise equity capital from them as the need arises Raising equity capital, via the back door of profit retention, saves issuing and other costs But, at the same time, it avoids the company having to be judged by the capital market as to whether it is willing to fund its future operations in the form of either equity or loans How much should companies borrow? There is no easy solution to this question But it is a vital question for corporate treasurers Borrow too much and the business could go bust; borrow too little and you could be losing out on cheap finance The problem is made no easier by the observation that levels of borrowing differ enormously among companies and, indeed, among countries Levels of borrowing in Italy, Japan, Germany and Sweden are generally higher than in the UK and the USA One reason is the difference in the strength of relationship between lenders and borrowers Bankers in Germany and Japan, for example, tend to take a longer-term funding view than UK banks Japanese banks may even form part of the same group of companies For example, the Bank of Tokyo, one of Japan’s CFAI_C13.QXD 10/26/05 11:42 AM Page 327 www.downloadslide.com Chapter 13 Treasury Management and working capital policy 327 leading banks, is part of the Mitsibushi conglomerate (www.mitsibushi.com) We devote Chapters 18 and 19 to the key question of how much a firm should borrow What form of debt is appropriate? If the strategic issue is to decide upon the level of borrowing, the tactical issue is to decide on the appropriate form of debt, or how to manage the debt portfolio The two elements comprise the capital structure decisions The debt mix question considers: (a) (b) (c) (d) form – loans, leasing or other forms? maturity – long-, medium- or short-term? interest rate – fixed or floating? currency mix – what currencies should the loans be in? The first three issues are discussed in Chapters 15 and 16 and currency issues are dealt with in Chapter 22 How you finance asset growth? Each firm must assess how much of its planned investment is to be financed by short-term finance and how much by long-term finance This involves a trade-off between risk and return Current assets can be classified into: (a) Permanent current assets – those current assets held to meet the firm’s long-term requirements For example, a minimum level of cash and stock is required at any given time, and a minimum level of debtors will always be outstanding (b) Fluctuating current assets – those current assets that change with seasonal or cyclical variations For example, most retail stores build up considerable stock levels prior to the Christmas period and run down to minimum levels following the January sales Figure 13.1 illustrates the nature of fixed assets and permanent and fluctuating current assets for a growing business How should such investment be funded? There are several approaches to the funding mix problem First, there is the matching approach (Figure 13.1), where the maturity structure of the company’s financing exactly matches the type of asset Long-term finance is used to fund fixed assets and permanent current assets, while fluctuating current assets are funded by short-term borrowings A more aggressive and risky approach to financing working capital is seen in Figure 13.2, using a higher proportion of relatively cheaper short-term finance Such an approach is more risky because the loan is reviewed by lenders more regularly For example, a bank overdraft is repayable on demand Finally, a relaxed approach would be a safer but more expensive strategy Here, most if not all the seasonal variation in current assets is financed by long-term funding, any surplus cash being invested in short-term marketable securities or placed in a bank deposit Capital (£) Fluctuating current assets Permanent current assets Figure 13.1 Financing working capital: the matching approach Fixed assets Time Short-term borrowing Long-term borrowing + equity capital CFAI_C13.QXD 10/26/05 11:42 AM Page 328 www.downloadslide.com 328 Part IV Short-term financing and policies Fluctuating current assets Capital (£) Short-term borrowing Figure 13.2 Permanent current assets Fixed assets Financing working capital needs: an aggressive strategy Long-term borrowing + equity capital Time Self-assessment activity 13.2 What you understand by the matching approach in financing fixed and current assets? (Answer in Appendix A at the back of the book) The issue of whether to borrow long-term or short term is examined in more detail in the next section 13.4 HOW FIRMS CAN USE THE YIELD CURVE In Chapter 3, we examined the term structure of interest rates showing the yields on securities of varying times to maturity The yield curve offers important information to treasury managers wanting to borrow funds Although it is based on the structure of yields on government stock, similar principles apply to the market for corporate loans, or bonds However, corporates have higher default risk than governments so that markets require higher yields on corporate bonds The market for government stock provides a benchmark that dictates the general shape of the yield curve with the curve for corporate bonds located above this Figure 13.3 reproduces Figure 3.3 with an additional yield curve to describe yields in the market for corporate bonds The distance between the two lines represents the premium required by the market to cover the risk of default by corporate borrowers For top-grade corporate borrowers, with a very high credit rating, the premium will be relatively narrow, whereas firms considered to be more risky will be subject to higher risk premia The corporate versus government yield premium would usually widen with time to maturity as corporate insolvency risk probably increases with time Today’s yield curve incorporates how people expect interest rates to move in the future An upward-sloping yield curve reflects investors’ expectations of higher future interest rates and vice versa The action points are clear: ■ ■ A rising yield curve may be taken to imply that higher future interest rates are expected This suggests firms might borrow long-term now, and avoid variable interest rate borrowing A falling yield curve may be taken to imply that lower future interest rates are expected This suggests firms might borrow short-term now, and utilise variable interest rate borrowing CFAI_C13.QXD 10/26/05 11:42 AM Page 329 www.downloadslide.com Chapter 13 Treasury Management and working capital policy Yield (%) Default risk premium 329 Yields on corporate bonds Yields on government securities Figure 13.3 Years to maturity Yield curves ■ Words of warning In some circumstances, managers may be deceived by short-term rates Say, they follow a policy of borrowing at short-term rates while the yield curve is upward-sloping, planning to switch to long-term borrowing when short-term rates exceed long-term rates For example, Jordan plc wants to borrow for six years, and the yield curve currently slopes upwards The yields on five-year and six-year bonds are 5.5 per cent and 5.8 per cent respectively, while the yield on one-year bonds is 5.0 per cent So, Jordan goes for one-year bonds, planning to issue a five-year bond a year later But what if, a year later, the whole yield curve shifts upwards due to macro-economic changes, e.g a rise in the expected rate of inflation, so that Jordan has to pay say, 7.5 per cent on a five-year bond? Obviously, this is now more expensive than arranging to lock in the 5.8 per cent rate at the base year Equally obviously, the reverse could apply – Jordan may benefit from a downward shift in the yield curve However, the point is that firms should not be over-influenced by relatively small differentials along the yield curve We examine specific methods of short- and medium-term borrowing in Chapter 15 and methods of long-term borrowing in Chapter 16 13.5 BANKING RELATIONSHIPS Many large companies deal with several banks in order to maximise their access to credit Global businesses may deal with hundreds of banks; Eurotunnel, at one time, had 225 banks to deal with! The number of banks dealt with will depend on the company’s size, complexity and geographical spread While it makes sense to have more than one bank, too many can make it difficult to foster strong relationships The real value of a good banking relationship is discovered when things get tough and when continued bank support is required We often hear the charge, particularly from smaller businesses, that banks are providing an inadequate service or charging too high interest rates It seems that the banking relationship can be more of a love/hate relationship than a healthy financial partnership A flourishing banking relationship requires the company to deal openly, honestly and regularly with the bank, keeping it informed of progress and ensuring there are no nasty surprises CFAI_C13.QXD 10/26/05 11:42 AM Page 330 www.downloadslide.com 330 Part IV Short-term financing and policies 13.6 RISK MANAGEMENT The financial manager should recognise the many types of risk to be managed: ■ ■ ■ Liquidity risk – managing corporate liquidity to ensure that funds are in place to meet future debt obligations We discuss this later in the chapter Credit risk – managing the risks that customers will not pay We discuss this in the next chapter Market risk – managing the risk of loss arising from adverse movements in market prices in interest rates, foreign exchange, equity and commodity prices It is this form of risk that we now consider Every business needs to expose itself to risks in order to seek out profit But there are some risks that a company is in business to take, and others that it is not A major company, like Ford, is in business to make profits from making cars But is it also in business to make money from taking risks on the currency movements associated with its worldwide distribution of cars? While the risks of business can never be completely eliminated, they can be managed Risk management is the process of identifying and evaluating the trade-off between risk and expected return, and choosing the appropriate course of action With the benefit of hindsight, it is all too easy to see that some decisions were ‘wrong’ In this sense, errors of commission are more visible than errors of omission; the decision to invest in a risky project which subsequently fails is more obvious than the rejected investment which competitors take up with great success As with all aspects of decision making, risk management decisions should be judged in the light of the available information when the decision is made The treasurer plays a vital role in identifying, assessing and managing corporate risk exposure in such a way as to maximise the value of the firm and ensure its long-term survival Self-assesment Activity 13.3 Take a look at the latest Annual Report of Cadbury Shweppes (www.cadburyschweppes.com) What does the Operating and Financial Review say about its treasury risk management policy? ■ Stages in the risk management process hedgers Hedgers tries to minimise or totally eliminate exposure to risk speculators Speculators deliberately take positions to increase their exposure to risk, hoping for higher returns Identify risk exposure Taking risks is all part of business life, but businesses need to be quite sure exactly what risks they are taking For example, while a firm will probably insure against the risk of fire, it may not consider the risk of loss of profits from the resulting disruption of the fire The Brazilian coffee farmer could see his whole crop wiped out by a late frost The UK fashion exporter could see her profit margins disappear because of the strong value of sterling Before any attempt is made to cover risks, the treasurer should undertake a complete review of corporate risk exposure, including business and financial risks Some of these risks will naturally offset each other For example, exports and imports in the same currency can be netted off, thereby reducing currency exposure Evaluate risks We saw in Chapter 8, that there are various ways in which the risks of investments can be forecast and evaluated The decision as to whether the risk exposure should be reduced will depend on the corporate attitude to risk (i.e its degree of risk aversion) and the costs involved Hedgers take positions to reduce exposure to risk Speculators take positions to increase risk exposure CFAI_Z07.QXD 10/28/05 11:29 AM Page 747 www.downloadslide.com Index defensive stock 728 Dell Computers 106 Delphi techniques 649 DeMonaco, L.J 566 deposit-taking institutions 27–8 deregulation of markets derivatives 25, 310–11, 728 and risk management 332–4 Deutsche Bank 542, 574 Deutsche Telekom 464 development capital 420 Diageo (company) 94 Dimson, E 40, 250–2, 292 direct debit 370 Director General of Fair Trading 545–6 directors’ dealings 424 disclosure 424 discount houses 27 discount rate 728 below growth rate 107–8 on investment projects 288–9, 532–3 and required return 253 and SVA 283–8 variable 131 discount tables 66–7 discounted cash flow (DCF) 100–3, 728 in project appraisal 157–9 in valuation 72, 100–3 discounted payback 128 discounting 65–8 disintermediation 29, 389, 728 Disney Corporation 173, 434 Dissanaike, G 40 diversifiable risk 242, 331, 728 diversification 220, 663, 728 and required returns 264 and risk 242, 331 by takeovers 551 divestment 576–7 dividend cover 54 dividend growth model 101, 105–6, 728 and firm value 451, 453 problems with 106–11 and shareholder value analysis 272–6 dividend irrelevance 451, 728 objections to 458–63 dividend per share 54 dividend puzzle 470–1 dividend restrictions 432–3 dividend stream, valuation of 104 dividend valuation model (DVM) 104–6, 450–1, 728 dividend yield 45, 55, 728 dividends 50 alternatives to 465–7 clientele effect 459–60 cuts in 451–4 external equity financing 457–8 and firm value 450–8 information content of 463–5 legal considerations 450 as residual 455–6 shareholders’ reliance on 458 shareholders’ risk 458–9 stable policy for 470 strategic considerations 449 and taxation 461–3 Dixit, A 316 dollar rates against sterling 594 domestic firms 642 double tax agreements (DTAs) 639, 728 doubles 303 Dow, Charles 38 Dow Jones index 44 Dow Theory 38 Doyle, Peter 544 Dresdner Bank 574 Drucker, P.F 563 Drury, J.C 398, 406 D.S Smith plc 323–4 due diligence 420, 542 Dun & Bradstreet 360 duration of long-term finance 413 Dynergy (company) 545 Eagle Star Insurance 549 earnings before interest and taxes (EBIT) 50, 728 earnings before interest, tax, depreciation & amortisation (EBITDA) 51, 98 earnings dilution 728 earnings per share (EPS) 10, 54–5 and takeovers 551–2 earnings stream, valuation of 96–7 earnings yield 108, 728 East, Warren 541 Eckert, Robert 181 economic exposure 599–600, 642–3 economic order quantity 364–5, 728 economic theory and currency risk 601–6 expectations theory 602 interest rate parity 603–5 international EMH 606 ‘Open Fisher’ theory 605–6 purchasing power parity (PPP) 602 economic value added (EVA) 111–12, 498–9, 728 747 CFAI_Z07.QXD 10/28/05 11:29 AM Page 748 www.downloadslide.com 748 Index effective rate of interest 399 efficiency frontier 226–7, 729 efficient market hypothesis (EMH) 35, 667 anomalies in 40–1 and CAPM 238 and chaos theory 41–2 criticisms of 40 fundamental and technical analysis 36–7 semi-strong form of 35 strong form of 35 weak form of 35 Egon Zehnder Associates 564 Eiteman, D.K 625, 656 Elton, E J 138, 463 Emap (company) 542 EMI (company) 545 Emirates Airline 441 enhanced scrip dividends 466, 729 Enron (company) 15–16, 545 Enterprise Investment Scheme 418, 729 enterprise value 90, 729 entrapment 669 entrepreneurial companies 412, 729 environmental aspects of investment 180–1 E.On AG (company) 98 equity beta 253, 286, 729 equity capital cost of 517–18 equity finance, raising of 417–31 AIM 424 equity issues 417–31 obligations 424 obtaining a quotation 423–4 quoted companies 421–2 rights issues 426–9 scrip issues 430 stock splits 430 unquoted companies 417–21 venture capital 418–21 equity options 310 equity values 90 equivalent loans 394–5, 729 equivalent risk classes 729 Euro Disney 173 euro rates against sterling 594 eurobonds 439–41, 729 Euronext 25 European Court of First Instance 545, 547 ‘European’ options 299, 619, 729 European Union 33 Merger Regulation 546 Eurotunnel 195, 314–15 exchange agio 604, 729 exchange controls 637 exchange rate forecasting 607–10 and central banks 609–10 and market efficiency 609 exchange rate management strategy 611 Exchange Rate Mechanism 9, 606 exchange rates and risk 642–5 structure of 596–7 ex-dividend 448, 729 executive share options 12, 16 exercise date 300 exercise price 299, 729 exit (from shareholding) 420 expectations 729 expectations theory 78–9 expected net present value (ENPV) 197 Export Credit Guarantee Department 651 export factoring 405 exporting 632 exporting firms 642 external hedging techniques 617–23 currency options 619–23 currency swaps 621–3 futures contracts 620–1 externalisation 632, 729 factor models 261–2 factoring 385–6, 729 Factors Chain International (FCI) 405 ‘fair game’ process 34 Fair Trading Act (1973) 545 Fama, Eugene 47, 234, 251, 260–1, 266 Farmers Insurance 549 Federgruen, Awi 206 Ferguson, A 43 Finance Act (1981) 578 Finance Act (1988) 449 Finance and Leasing Association (FLA) 389 Finance Corporation for Industry 581 finance departments 9–10 finance function 5–7 changes in 670–1 investment decisions 6–7 finance leases 392–3, 729 financial assets ‘financial characteristics’ approach to mergers 568 financial decisions financial distress 499–503, 729 costs of 526 MM on 526–7 CFAI_Z07.QXD 10/28/05 11:29 AM Page 749 www.downloadslide.com Index financial gearing 484–6, 729 and risk 486–9 financial institutions 25–7, 729 financial management 8–9 financial markets 24–7 efficiency of 34–41 financial objectives 10–11 financial pages, reading of 44–6 financial ratios 52–3, 433 financial reports 433 financial risk 199 Financial Services Act (1986) 32 Financial Services Authority 32, 729 financial services sector 27–30 savings institutions 28–9 unit and investment trusts 29 financial statement analysis 48–56 balance sheets 48–50 cash flow statements 51 interpretation of accounts and ratios 55–6 profit and loss accounts 50 ratios 51–5 Finnie, J 190 Fireball QXL 439 Firer, C 292 first-year allowances 156, 401 Firth, M 506, 656 Fison’s (company) 549 fixed assets new investment in 280 fixed charges 383, 729 fixed costs 199 fixed/fixed swaps 623 fixed/floating swaps 623 fixed-interest securities 553 flat yield 437, 729 flexible manufacturing systems (FMSs) 178 floating charges 383, 729 floating rate notes (FRNs) 441, 729 Foley, B.J 47 follow-on opportunities options 312 football clubs, quoted 93–4 Ford, Henry 180 Ford Motor Company 345 foreign bonds 439, 729 foreign currency swaps 617, 729 foreign direct investment (FDI) 729 APV for 654–5 evaluation of 638–41 factors in favour of 247–8 financing of 651–3 WACC for 653–4 749 foreign exchange exposure 636, 642–6, 729 and currency risk 598–600 foreign exchange management (FEM) strategy 610–13 hedging translation exposure 610–13 transaction exposure 612–13 foreign investment complexities of 636–7 entry strategies 632–4 evaluation of 638–41 exchange controls 637 foreign exchange risk 642–5 incremental hypothesis 634–6 by multinational corporations 631–2 operating exposure 645–6 political and country risk 647–51 taxation differences 639–41 forfaiting 404, 729 Forgeard, Noel 210 Forte’s (company) 467 forward contracts 332, 617, 729 forward-forward swaps 618 forward market 25, 596 forward options 617, 729 forward premiums 597 forward rates of exchange 643, 730 forward vertical integration 550 Fosback, N 242 Francis, J.C 263 Francis, S.C 566 Franks, J 288, 570–1, 582 free cash flow (FCF) 101–3, 514, 730 French, Kenneth 251, 261, 266 Friedman, M 254 FT-SE indices 44–6 full-payout leases 392 fundamental analysis 36–7, 730 in exchange rate forecasting 605–9 future value 63 futures 25 currency contracts 620–1 risk management 333–4 Gale, B.T 18 Gapenski, L.C 374 Gates, Bill 177 GE Capital 435, 566 gearing in cash flow statements 53 effect on ROE 488 measures of 480–2 MM on 516 traditional view of 489–92 and WACC 529–30 CFAI_Z07.QXD 10/28/05 11:29 AM Page 750 www.downloadslide.com 750 Index General Electric (GEC) 175, 467, 545, 561 General Motors 345, 478 general valuation model (GVM) 100 generally accepted accounting principles (GAAP) 50, 92–3, 730 generic swaps 336 Gentry, J 348 Ghosh, C 465 Giddy, I.H 625 Gitman, L.J 290–1 GKN plc 466 Glaum, M 613, 625 global companies 412, 642, 730 Gluck, F.W 582 going-concern value 730 golden handcuffs 103 golden parachutes 562 Google 411 Gordon, Myron 458, 473 government stock 78 Graham, B 449 Granada (company) 467 Grand Metropolitan Hotels 94 Graves, S.B 43 Gray, S.J 582 Gregory, Alan 552, 570, 572, 583 gross redemption yield 78 Group Securicor 575 Grubb, M 251, 288 Gruber, M 463 Gup, B.E 292 Halifax (bank) 567 Hamada, R.S 523 Hand, James 661, 670 ‘hands on’ shareholding 421 Hanson (company) 593 Harrington, D.R 292 Harris, R.S 570, 582 Harrison, J.S 560 Harrison, R 417 Harry Potter 133 Hass, J.E 212 Hatzopoulos, P 158, 160, 164, 188, 210 HBOS plc 567 hedging 646–7, 730 and currency risk 594–5 and interest rate risk 336 and risk exposure 330 and risk transfer 331 with share options 302–4 Helliwell, J.F 212 Henderson, S.K 625 herd behaviour 668 Hertz, D.B 207 heuristics 670 highly-leveraged transactions (HLTs) 502 Hill, N 374 hire purchase 389–91, 730 Hirshleifer, J 37 Ho, S.M 212 Hodgkinson, L 164 Holland 656 Holmes, D.E.A 164, 188 home-made dividends 458, 473–4, 730 home-made gearing 516, 730 Honeywell (company) 545 horizontal integration 549, 730 hostile bids, chronology of 547–8 Hunt, J 564 hurdle rates in SVA 290–1 hybridity 730 Hypobank 542 ICAEW 95 ‘illusion of control’ bias 667 importing firms 642 improvement proposals in capital investment 185 imputation systems 462, 730 ‘in the money’ situations 299, 304 income gearing 482–3, 730 income statements 50 incremental cash flow analysis 148–51 incremental hypothesis 634–6, 730 incrementalism 663 independent venture capital firms 419 Indonesia 655–6 industrial cooperation joint ventures 579 inflation in project appraisal 153–4 and time-value of money 62 information asymmetry 39, 420, 505, 663, 726, 730 and capital rationing 135 and dividend policy 463–5 information content 663, 730 information efficiency of markets 34 information processing, human 666 information technology 244 inherent shareholder value 279 Inion (company) 33–4 initial public offerings (IPOs) 421, 579, 730 Inland Revenue 155 CFAI_Z07.QXD 10/28/05 11:29 AM Page 751 www.downloadslide.com Index insider trading 730 insolvency 499–500, 513 Insolvency Act (1986) 500 insurance companies 28 and loan guarantees 310 and risk transfer 331 ‘insured’ schemes 28 intangible assets 48–9, 93 interest Agio 604, 730 interest cover 54, 482–3, 730 interest rate exposure 335–6 interest rate management 335–7 interest rate options 310 interest rate parity (IRP) 603–5, 730 interest rate swaps 336 interest rates calculation of 70–1 changes in 63, 505 factors affecting 73 interest yield 437 intermediaries offers 424 internal hedging techniques 614–17 internal rate of return 70–1, 730 and investment appraisal 125–7 internalisation 632, 634, 730 ‘international’ bonds 439–41 international diversification 243 International Fisher Theory 605, 730 International Monetary Fund (IMF) 76 International Power plc 429 International Reporting Standards 92 international trade 402–5 documents for 403 Internet bubble 41 intrinsic worth of shares 36, 304 inventory management 362–7 investment categories in SVA 279–80 investment-consumption decision 79–84 investment decisions 6–7, 182 accounting rate of return 129–30 and capital rationing 134–7 cash flow analysis 122 constraints on 134 and financing decisions 150 IRR techniques 125–7 NPV techniques 123–5 payback period 128–9 profitability index 127–8 ranking of mutually exclusive projects 130–3 investment portfolios 28–9, 220 investment risk see risk 751 investment strategy advanced manufacturing technology investment 178–80 capital investment process 181–7 considerations in 174–8 environmental aspects 180–1 post-auditing 188–9 investment trusts 29 investor ratios 54–5 Investors for Industry (3i) 419, 465, 581 invoice discounting 386–7, 730 irredeemables 69, 78, 492 issue by tender 423 Issuing Houses Association 27 Jackson, Michael 434 Jarvis, R 406 Jensen, M.C 11, 40, 550, 570, 582 Johanson, J 634 John Lewis Partnership 13–14 joint-equity ventures 579 joint ventures 579–80, 730 Jolliffe, Alexander 579 Jones, C.S 563–4, 582 Jowit, Juliette 314–15 Junankar, S 289 junk bonds 432, 730 Jupe, R.E 103 just-in-time planning 366–7 kanban system 367 Kaplan, R.S 179, 190 Kaplan, S.N 502 Kaplanis, E 243 Keane, S, 47, 459, 506, 656 Keelin, T 236 Kelda Group 448 Kenning Motor Group 569 Kester, W.C 316 Keynes, J.M 41 Kindleberger, C.P 625 Klemm, M 558 K-Mart 503 KPMG (consultancy) 571–2, 579 Kuwano, Yukimori 175–6 lagging 615, 730 Lane Cove Tunnel Finance 439 Larcker, D.E 183 Late Payments of Commercial Debts (Interest) Act (1998) 382 Law of One Price 34, 634, 730 CFAI_Z07.QXD 10/28/05 11:29 AM Page 752 www.downloadslide.com 752 Index leading 615, 730 leasing 391–402 as an alternative source of funds 397 cash flow advantages of 397–8 and corporation tax 398–402 cost of 398 ‘equivalent loan’ concept 394–5 evaluation of 393–6 as a financing decision 395–6 in long-term finance 441–3 motives for 396–8 and off-balance sheet financing 398 types of 392 Leeds United FC 435 Lees, S 558, 564, 572 Leeson, Nick 333 letters of credit 403, 730 leverage ratio 485 leveraged buy-outs 562 Levis, M 261 Levy, H 164 licensing 559, 632–3, 731 limited liability 4–5 Limmack, R.J 570 Lindley plc 486–7 linear programming 139–43 Lintner, J 464 liquidation 499–500 liquidity and dividend policy 465–7 management of 338 risk to 330 transformation 27 liquidity preference theory 78–9 liquidity ratios 53 listed companies 731 listing rules 31 ‘living dead’ companies 421 Lloyd-Webber, Andrew 100 Lloyds TSB 545 Lo, Andrew 38 loan capital Loan Guarantee Scheme 384–5, 731 loan stock 310, 432 local investment networking companies (LlNCs) 417 London, Simon 671 London Inter-Bank Offer Rate (LlBOR) 387, 438 London International Financial Futures and Options Exchange (LlFFE) 25 London Stock Exchange 30–4 European market 33 history 30–1 market regulation 32 share ownership 33 long-term finance corporate aims 412–13 debt instruments 432–41 leasing and sale-and-lease-back 441–3 raising of 413–14, 417–31 shareholder funds 414–17 long-term incentive plans (LTIPs) 12 Lorie, J.H 138 Lucent (company) 545 Luehrman, T.A 534 McBeth, J 260 McDaniel, W.R 138 McDermott, M.C 582 McGowan, C.B 263 McIntyre, A.D 164 MacKinlay, Craig 38 McKinsey-General Electric portfolio matrix 174–5 McRae T.W 625 Madura, J 550, 625, 656–7 management buy-ins (MBIs) 420, 731 management buy-outs (MBOs) 419, 421, 438, 577–8, 731 checklist for success of 578 managerial incentives 12 managerialism 11 managers, corporate 668–9 Manchester United FC 93 Mannesmann (company) 567 Manson, C 571 Mao, J.C.T 212 Marais, D 339 Marconi (company) 24, 542 marginal cost of capital (MCC) 495, 731 marginal efficiency of investment (MEI) 456, 731 market behaviour, understanding of 664–5 market capitalisation 50, 731 market efficiency 34–41 implications of 38–9 increases in 39 market inefficiency 661 market model 245–6 market portfolios 241, 256, 731 market risk 199, 330 market segmentation theory 78–9 markets, access to Markowitz, H.M 234 Marsh, P 40, 43, 47, 292 Mason, C 417 matching 327, 615, 731 materials requirement planning (MRP) 366 CFAI_Z07.QXD 10/28/05 11:29 AM Page 753 www.downloadslide.com Index Mathur, I 570 Mattel (company) 181 maturity of stock 78 Mayer, C 571 Meall, L 499 mean-variance rule 203 Meckling, W.H 11 Mehra, R 250 mental accounting 670 Mercer (consultancy) 571 Merchant, Khozem 636 merchant banks 27–8 mergers 8, 731 assessing the impact of 567–72 integration sequence for 564–6 for management control 550 post-merger integration 563–7 Merton, R 316 Metro (company) 219 mezzanine finance 438, 731 Microsoft 106, 177, 431 Miller, F.H 234 Miller, M 373–4, 448, 451, 458–9, 473, 480, 506, 513–15, 534 Mills, R.W 164 Milner, Charles 579 Milunovich, Steve 471 minimum-risk portfolio 225, 230 modified internal rate of return (MIRR) 138–9, 731 Modigliani, F 448, 451, 458–9, 473, 480, 513–15, 534 Modigliani and Miller (MM) capital structure theories 731 Monetary Policy Committee 731 money market cover 618, 731 Monopolies and Mergers Commission (MMC) 427 Monson, Guy 72 Monsoon (company) 626 Monte Carlo simulation 207 moral hazard 420, 503, 731 Morgan, Michael 468–9 Mossin, J 259 multilateral netting 614, 731 multinational companies (MNCs) 631, 731 advantages of 631–2 multi-period capital rationing 137, 139–43 multi-period cash flows and risk 212–14 Murdoch, Rupert 562 Muscovy Company 5, 30 mutually exclusive projects, ranking of 130–3 My Travel (company) 512 Myers, S.C 138, 266, 316, 374, 406, 506, 530, 534 naked options 300 Nalco (company) 635–6 Narayanaswamy, V.J 406 De Nationale Investerings-bank 435 natural hedging 335, 645 , 731 natural matching 615 NatWest Bank 567 Navenby plc 99–100, 105–6 Neale, C.W 164, 188, 190, 636 negative returns 487 Nestlé (company) 94, 435 net advantage of a lease (NAL) 394, 396, 731 net asset value (NAV) 90, 731 in brand valuation 96 problems with 92–4 net book value 49 net current assets 50 net debt 481, 731 net present value (NPV) 67, 73–6, 664, 731 adjusted for risk 208–10 and DCF 123–5 theoretical case for 79–80 and unconventional cash flows 132 net working capital 337–8 netting 614, 731 neutral stocks 731 new issue markets 731 new product proposals in capital investment 185 New York Stock Exchange 33 News Corporation 434, 562 niche companies 412, 731 Nikkei index 44 nil paid price of rights 427 Nintendo (company) 595 non-financial goals of management 11 non-recourse 731 Norwood, S.W 292 notes (securities) 432 offers for sale by prospectus 423 Office of Fair Trading 32, 427, 583 Official List (of companies) 44, 731 open accounts 402 ‘Open Fisher’ theory 603–4 open offers 429 operating clauses 392 operating efficiency of markets 34 operating exposure 642–4, 732 management of 645–6 operating gearing 198–9, 286–7, 413, 484–6, 731–2 operating leases 732 operating leverage 485 operating profit 50 operational strategy 17 753 CFAI_Z07.QXD 10/28/05 11:29 AM Page 754 www.downloadslide.com 754 Index opportunity costs 663, 732 in project appraisal 148–9 opportunity sets 226, 230–1 optimal capital structure 225, 479, 732 optimal portfolio 225, 227, 732 option contracts 299 option to abandon 311–12 option to wait and see 312, 314 options 25, 732 ordering costs 345 ordinary share capital 8, 414–15 Orr, D 373, 374 O’Shea, D 47 Osler, C 607 ‘out of the money’ situations 299 outrights 597 over-the-counter (OTC) market 31, 619 overconfidence on the part of investors 670 overdrafts 732 overreaction hypothesis 40 overseas banking 28 overstocking 362 overtrading 346–7, 732 consequences of and remedies for 347 owner’s equity 732 ownership and long-term finance 413 transferability of Pacman defence 562 parallel matching 615, 645, 732 part-payout leases 392 participating shares 416 patents 633 payback period 128–9 in investment decisions 128–9 in project appraisal 160–2 Payne, A.F 582 payout ratio 448 Peacock, A 567 pecking order theory 505 Peel, M.J 583 pension funds 28 PepsiCo 580, 637 perfectly-correlated cash flows 213 perpetual warrants 437 perpetuities 732 present value of 84–5 valuation of 69 Peters, E 42, 47 Peterson, P.P 406 Pettit, J 473 Pike, R.H 67, 134, 138, 158, 164, 190, 210, 212, 374 Pilkington’s (company) 239–40 Pinches, G 164 Pindyck, R 316 placing 423 with clawback 425 ‘plain vanilla’ swaps 336 ‘plain vanilla’ debt 733 plant hire 392 Pohlman, R.A 164, 290–1 Pointon, J 164 ‘poison pills’ 562, 732 political risk 647–51, 732 Poon, S 261 Porter, M.E 559, 567 portfolios 220, 732 portfolio effect 220–2, 732 portfolio insurance 303 portfolio investment 732 portfolio management 29 portfolio risk 199 portfolio theory correlation in 227–31 on project appraisal 233–4 principles of 221–2 risk measurement 223–5 risk in relation to return 226–7 with three or more components 231–2 post-completion auditing 188–9, 563, 732 Prasad, S.B 656–7 pre-emption rights 425 preference shares 415–16, 732 for financing a takeover 553 preferential borrowing 396 premiums on option prices 299 on share prices 415 Prescott, E.C 250 present value 65–9 arithmetic of 68–71 discount tables 66–7 formula for 84–5 of perpetuities 84–5 present value interest factor (PVIF) 66, 125 for annuities (PVIFA) 66, 85 Price, Colin 574 Price, J 625 price/earnings ratio (PER) 45–6, 54, 89, 732 and constant dividend valuation model 108–9 price-to-earnings multiple 96–7 price variation 616 pricing efficiency of markets 34 CFAI_Z07.QXD 10/28/05 11:29 AM Page 755 www.downloadslide.com Index primary capital markets 25 principal-agent relationship 11 Prindl, A 625 private equity firms 425–6 private placing 420 profit after tax (PAT) 50 profit and loss accounts 50 profit before interest and tax (PBlT) 485, 514 profit centre treasuries (PCTs) 326 profit margins 52 profit retention 10 profitability index 127–8, 732 profitability ratios 52 project appraisal ARR methods 159–60 DCF techniques 157–9 fixed overheads 150 incremental cash flow analysis in 148–50 and inflation 153–4 payback period in 160–2 portfolio analysis in 233–4 replacement decisions 151–3 and taxation 155–7 project finance 178 project risk factors 288, 732 proprietorial companies 412, 732 prospective earnings yield 728 prospectuses 423, 425 protective puts 303 provisions 732 proxy beta 732 Pruitt, S.W 290–1 psychology of economics 671 purchasing power parity 732 pure play technique 285 put options 299–300 put-call parity 304–5 Qantas Airways 501–2 quadratic programming 231 Quaker Oats Company 10, 98, 271–2 quick assets 53 quick ratio 338 quotation seeking 421–4 quoted companies 421–2 Radebaugh, L.H 656 random walk theory 732 Rank-Hovis-McDougal 94 Rappaport, A 47, 109, 279 real assets 6, 732 real options 311, 732 755 Really Useful Group 100 rebate clauses 392 receivership 499–500 recognised investment exchanges (RlEs) 32 record day 448, 732 redeemable shares 416 redemption yield 437 Redhead, K 47, 316 regulation of markets 32 Reichmann, Paul 127 Reimann, B.C 290–2 re-invoicing centres 616 relevant risk 732 Rensburg plc 419 re-packaging finance 27 replacement chain approach 164–5 replacement cost 92 replacement decisions 151–3 replacement investment 279–80 replacement proposals in capital investment 185 required return assessment of 250–4 traditional view of 489–92 reserves 416, 732 residual income 160 residual theory of dividends 455–6, 732–3 resourceful, evaluative, maximising model (REMM) 662 restrictive covenants 432 retail banking 27 retained earnings 733 retained profits 8, 50 return on capital employed (ROCE) 52, 129 return on equity 54, 487–8 return from holding shares 239–40 return on shareholder’s funds 54 revaluation reserves 416 revenue sensitivity 286, 733 revolving credit facility 384, 733 rights issues 425–9, 733 and dividends 460–1 rights lapse 428 risk adjusted NPV 208–9 attitudes to 197–8 expected net present value (ENPV) 197 in factoring 385–6 in financial decisions 16–17 and financial gearing 486–9 in long-term finance 413 measurement of 200–3 multi-period cash flows 212–14 and return 226–7, 239–42 CFAI_Z07.QXD 10/28/05 11:29 AM Page 756 www.downloadslide.com 756 Index risk (continued) and time-value of money 62 scenario analysis 206 sensitivity analysis 204–6 simulation analysis 207 types of 198–200 risk-adjusted discount rate 208–9 risk aversion 197, 663 in portfolio theory 222 with share options 302–4 risk avoidance 331 risk exposure 330 risk-free assets 255–7, 733 risk management 330–7 and derivatives 332–4 and hedging 334–5 interest rate management 335–7 stages in 330–2 risk minimisation policy 613 risk premiums 16, 249, 733 risk reduction 27, 331 risk retention 331 risk sharing 616 risk transfer 331 R.J Reynolds Tobacco 121 Robbie, K 583 Robbins, S 636 Rodriguez, R.M 625 Roll, R 40, 266 Ross, S.A 40, 260, 262, 504 Rowntree’s (company) 94 Royal Bank of Scotland 567 Royal Dutch Shell Group 181 Ruback, R.S 570, 582 Rugman, A.M 656 Rutherford, B.A 103 Rutterford, J 406, 443, 506 safety stocks 366 Saigol, Lina 181 Sainsbury’s (company) 442 sale-and-leaseback (SAL) 441–3 sale-and manage-back 442–3 Sanyo Electric 175–6 Sarbanes-Oxley Act (2002) 15 Sarnat, M 164, 212 Sartoris, W 374 Savage, L.J 138 scale economies 549, 733 scenario analysis 206 Scholes, M 308, 316 Schumpeter, Joseph 15 Scottish & Newcastle (company) 550, 580 scrip dividends 465–6, 733 scrip issues 430, 727 second-round financing 421 secondary capital markets 25 secondary leases 392 Securicor (company) 575 securitisation 29–30, 434, 733 security market line (SML) 249, 733 seed capital 421 segmental beta 284 Seiyo Food Systems 549 self-administered pension schemes 28 self-deception 666, 670 sell-offs 576 Seminole Indian tribe 435 semi-variance 202 sensitivity analysis 204–6, 733 and multi-period capital rationing 140, 142–3 separation theorem 83, 256 Shao, L.P 656 Shapiro, A.C 625, 656 share buybacks 562, 733 share exchanges for financing takeovers 553 share options 12, 16, 297–304 and corporate finance 309–10 and futures 334 as a hedge 302–4 pricing of 304–9 speculative use of 300–2 terminology 299 share premium accounts 415, 733 share splits 430, 733 share valuation 669 share warrants 309 shareholder value, maximisation of 10 shareholder value analysis (SVA) 109–12, 733 cost of equity 272–3 hurdle rates 290–1 investment categories in 279–80 required return 276–8 tailored discount rates 283–9 taxation and the CAPM 288–9 value drivers in 278–80 shareholder wealth and social responsibility 13–14 shareholders’ funds 50, 414–17 authorised and issued share capital 414 ordinary shares 414–15 preference shares 415–16; see also dividends Sharpe, P 236 Sharpe, W.E 231, 234, 238 Sherlund, Rick 471 CFAI_Z07.QXD 10/28/05 11:29 AM Page 757 www.downloadslide.com Index short- and medium-term finance bank credit 382–5 bill finance 387–9 factoring 385–6 hire purchase 389–91 for international trade 402–5 invoice discounting 386–7 leasing 391–402 trade credit 380–2 short selling 733 short-term asset management cash management 367–73 inventory management 362–7 investment 373 trade credit 354–61 short-term investment 373 short-termism 43–4 shortage costs 344 Siemens (company) 561 sight drafts 403–4 signalling 504, 663, 733 Silicon Valley 471 simple interest 63 simulation analysis 207 single-period cash flows 200–2 Sirower, Mark 574–5 Sistema (company) 422 Skapinker, Michael 574–5 Smith, Adam 13 Smith, K.V 348 SmithKline Beecham 236 social efficiency of markets 34 social responsibility 13–14 Solnik, B.H 243 South Sea Bubble 41 special purpose vehicles (SPVs) 434 specific risk 241–2, 733 speculators 330 spin-offs 577 spot-forward swaps 618 spot markets 596 spot rates 733 spread 596–7, 733 standard deviation 200–1, 240 start-up capital 421 statutory proposals for capital investment 185 sterling/dollar option rates 619 sterling exchange rates 594–5 Stern Stewart (consultancy) 111 Stewart, Rod 434 Stobaugh, R 636 Stock Exchange Automated Quotations (SEAQ) system 31, 46, 733 757 Stock Exchange Electronic Trading Service (SETS) 31 Stock Exchange introduction 424 stock splits 430, 733 stockholding periods 53 stockouts 366 Stonewall plc 610 straddles 303 strategic exposure 642–3, 732 strategic investment options 313–14 strategic opportunities 560 strategic portfolio analysis 174 strategic proposals for capital investment 185 strategy in financial decisions 17–19 strike prices 299, 619 Strong, N 261, 266 Sudarsanam, P.S 570, 583 sunk costs 149, 663, 733 supplier credit days 53 sustainable competitive advantage 174 Swalm, R.O 233, 291 swaps 334, 621–3 Swire, D.J 18 Swiss franc rates against sterling 594 switchover costs 635 SWOT analysis 559, 561 synergies 549, 733 systematic returns 246–7 systematic risk 241, 733 and security valuation 244–8 tailored discount rates in SVA 283–9 Takeover Code 547, 733 Takeover Panel 32, 547, 733 takeovers acquisition criteria 560–1 bidding 561–2 creation of value 548–50 defence tactics 561–2 evaluation of bids 554–7 failure of 557–8 financing of bids 552–3 hostile 547–8, 777 motives for 548–52 regulation of 545–7 strategy for 557–62 waves of activity 542–8 taking-up rights 428 tangible fixed assets 48–9 tax breaks 733 tax credits 733 tax irrelevance thesis 463 tax shield 493, 520, 522, 733 CFAI_Z07.QXD 10/28/05 11:29 AM Page 758 www.downloadslide.com 758 Index taxation 46 as cash flow 155–7 and dividend growth model 275–6 and foreign investment 639–41 in project appraisal 155–7 Taylor, S.J 261 technical analysis 36–7 exchange rate forecasting 608 technical efficiency of markets 34 term structure of interest rates 73, 78–9 terms of trade 356 Tesco (company) 46, 442 Tetley (company) 631 Theakston’s (company) 550 theoretical ex-rights price (TERP) 427, 733 theory and practice of finance 665 Thomas, S.H 163 time-value of money 62–3, 304, 664, 733 times interest earned 482 timing options 314, 416 tin parachutes 562 Tobin, J 77, 234, 571 Tomkins, C.R 164, 406 total shareholder return (TSR) 239–40, 734 Toyota (company) 367 Tozer Kemsley Milbourn (company) 569 trade credit 734 cash discounts 357–8 collection policy 358–60 credit periods 356 credit standards 356–7 debtors as security 360 management of 354–61 reasons for 354–5 for short- and medium-term finance 380–2 Trade and Industry, Department of 43, 384, 570 Trade and Industry, Secretary of State for 545–6 trade-off theory 505 trade sales 421 traded options 299 traditional economic model of human behaviour 662 traditional options 299 traditional theory of capital structure 480, 491, 734 traits of behaviour 666 transaction exposure 598, 734 transfer prices 734 translation exposure 598–9, 734 Treasury bills 16, 196, 734 treasury function 324–6 banking relationships 329 cash operating cycle 340–1 centralisation 325 funding 326–8 overtrading 346–7 predicting failure 339–40 risk management 330–7 working capital management 337–9 working capital policy 342–6 Tricks, Henry 454–5 Trigeoris, L 316 Triton Energy 550 Trump Hotels 500 two-factor model 262 uncertainty 196 undercapitalisation 346 underlying options 297 understocking 362 undervaluation 548 underwriting 427 Unilever (company) 580 unit trusts 29, 734 United Nations Conference on Trade and Development (UNCTAD) 631 unprofitable projects and strategies 669 unquoted companies raising equity finance 417–21 valuation of 103 unsystematic returns 246–7 Usinor (company) 543 Ustunel, Sarpel 96 utility and risk 197 Vaga, T 42 valuation 89–90 of cash flows 98–100 DCF approach to 100–3 dividend valuation model 104–5 of earnings streams 96–7 and EBITDA 98 and free cash flow 101–3 problem of 89–90 of shares 104–5 of unquoted companies 103 use of published accounts for 90–6 value additivity 548 value-based management 734 value creation process 575–6 value drivers 110, 278–80 value gaps 573–5 and bidding 574–5 and corporate parenting 573 and financial management 573 and stock market efficiency 575 CFAI_Z07.QXD 10/28/05 11:29 AM Page 759 www.downloadslide.com Index Van Home, J 255 Van Ryzin, Garrett 206 variable costs 199 Venables, Terry 513 vendor placing 425 venture capital 419–21, 734 and MBOs 577–8 venture capital trusts 418–19 Vereinsbank 542 vertical integration 549, 734 Virgin Group 100, 147, 196 Vneshtorgbank 439 Vodafone (company) 92, 468, 567 volatility of share prices 299 Volkswagen (company) 593 Waitrose (company) 13 Walters, A 583 warrants 437–8, 734 Waste Management 580 Waters, Richard 471 wealth, measurement of 61 Weaver, S.C 188–9 weighted average cost of capital (WACC) 490–1, 496–8, 694, 734 calculation of 527–30 and capital structure 514 and debt/equity ratio 515–17, 534–5 and FDI 653–4 and gearing 529–30 MM on 514–17 required conditions for 496 at Tomkins plc 496 Weingartner, H 138 welfare proposals for capital investment 185 Wessex Water 580 Weston, J.F 47, 234, 266, 443, 473, 506, 534 Whitbread plc 278, 285 ‘white knights’ 562, 734 wholesale banks 27–8 Whyte, A.M 657 Wiedersheim-Paul, F 634 Wilkie, A.D 251, 288–9 Wilson, M 636, 656 Wilson Committee 134 Wolfe, M 164 Woolridge, J 465 working capital 50, 734 investment in 279 management of 337–9 in project appraisal 150 working capital costs 34 working capital policy 342–6 World Bank 76 World Trade Organisation 251 Worldcom (company) 92 Wright, M 583 writing-down allowances 156, 390, 398 Xu, X.G 261, 266 yen rates against sterling 594 yield 46, 734 yield curves 78–9, 328–9, 734 z-scores 339–40, 734 zero coupon bonds 433, 734 zero-sum game, options as 620 759 CFAI_Z07.QXD 10/28/05 11:29 AM Page 760 www.downloadslide.com CFAI_Z08.QXD 10/28/05 11:34 AM Page www.downloadslide.com FORMULAE Asset or Activity Beta ϭ 3Equity Beta ϫ proportion of Equity4 ϩ 3Debt Beta ϫ proportion of Debt4 ϭ Beta ungeared Beta ϭ Covjm> sm2 ϭ 3rjm sj sm 4> sm2 ϭ rjm sj 4>sm Beta Geared: ϭ Beta u ϫ c ϩ Beta Ungeared ϭ T ϫ VB d VS Beta g c1 ϩ T ϫ VB d VS Capital Market Line: ER p ϭ R f ϩ 3ER mϪ R f ϫ sp om N aXt Ϫ I0 Certainty Equivalent ϭ NPV ϭ a t tϭ1 11 ϩ i2 Constant-Growth Dividend Valuation Model (Dividend Growth Model): Po ϭ Do 11 ϩ g2 4> 1ke Ϫ g2 Cost of equity in a geared firm (MM Proposition 1: no tax): keu ϭ keu ϩ 1keu Ϫ kd VB>VS Cost of equity in a geared firm – MM with tax: keu ϭ keu ϩ 1keu Ϫ kd 21 Ϫ T2.VB>VS N Covariance of Returns of a Two-Asset Portfolio: covAB ϭ a pi1RA Ϫ ER A 21RB Ϫ ER B Exchange Agio: ϭ 1Forward Rate Ϫ Spot rate2>Spot rate iϭ1 Expected Return from a Two-asset Portfolio: ER P ϭ aER A ϩ 11 Ϫ a2 ER B Forward rate of exchange: ϭ 1spot rate ϩ forward discount2, or (spot rate minus forward premium) Free Cash Flow ϭ 3Revenues Ϫ Operating Costs ϩ Depreciation Ϫ Investment Expenditure4 Interest Agio: ϭ difference between foreign and domestic interest rates 11 ϩ domestic interest rate2 Interest Rate Parity: 11 ϩ foreign interest rate2 Forward rate ϭ spot rate ϫ 11 ϩ domestic interest rate2 Xt ϭ0 Internal Rate of Return 1r2: a 11 ϩ r2 t n tϭ0 NAV ϭ Total Assets Ϫ Total Liabilities4 n Xt Net Present Value ϭ NPV ϭ a Ϫ I0 11 ϩ k2 t tϭ1 1 Present Value of Annuity ϭ PVIFA1i,n2 ϭ a Ϫ b i i11 ϩ i2 n Project Risk Factor ϭ Revenue Sensitivity Factor ϫ Operating Gearing Factor4 Purchasing Power Parity: 11 ϩ foreign inflation rate2 Forward rate ϭ Spot rate ϫ 11 ϩ domestic inflation rate2 Real rate of return ϭ 11 ϩ M2>11 ϩ I2 Ϫ Risk-minimising Portfolio Weightings: aA* ϭ sB2 Ϫ covAB sA2 ϩ sB2 Ϫ 2covAB Security Market Line (CAPM): ke ϭ R f ϩ bj ER m Ϫ R f Standard deviation of a Two-asset Portfolio: sp ϭ 33 a2s2A ϩ 11 Ϫ a2 2s2B ϩ 2a11 Ϫ a2covAB Tax Shield ϭ TiB>i (if a perpetuity) Total Shareholder Return: TSR ϭ R jt ϭ 3Djt ϩ 1Ptϩ1 Ϫ Pt 4>Pt Value of a Geared Firm – MM with tax: Vg ϭ Vu ϩ TB Weighted Average Cost of Capital: WACC ϭ 3ke ϩ VS>1VS ϩ VB ϩ 3kd 11 Ϫ T2 ϫ VB>1VS ϩ VB Or VB k0 ϭ keu c Ϫ T a bd VS ϩ VB Zero-Growth Dividend Valuation Model: Po ϭ D>ke ... Debtors Cash and marketable securities 32 28 12 72 Aggressive policy (£m) 25 22 – 47 It will be seen that the relaxed policy requires a further 25 million investment in working capital over and above... Chapters 15 and 16 and currency issues are dealt with in Chapter 22 How you finance asset growth? Each firm must assess how much of its planned investment is to be financed by short-term finance and. .. the year 22 ,000 426 ,000 448,000 (26 ,000) (176,000) (38,000) (7,000) £ 422 ,000 23 8,000 (22 1,000) 17,000 (6,000) 11,000 (1,000) 10,000 The company is family-owned and controlled and, since incorporation,