Business Finance: Theory and Practice Book by E.J. McLaney

Guided tour of the book xii
Preface xv
Plan of the book xvii
Part 1 The business finance environment
1 Introduction 3
Objectives 3
1.1 The role of business finance 4
1.2 Risk and business finance 5
1.3 The relationship between business finance and accounting 6
1.4 The organisation of businesses – the limited company 6
1.5 Corporate governance and the role of directors 9
1.6 Long-term financing of companies 12
1.7 Liquidation 14
1.8 Derivatives 15
1.9 Private equity funds 16
Summary 17
Further reading 18
Relevant websites 18
Review questions 18
2 A framework for financial decision making 19
Objectives 19
2.1 Financial decision making 19
2.2 Business objectives 21
2.3 Conflicts of interest: shareholders versus managers – the
‘agency’ problem 26
2.4 Financing, investment and separation 28
2.5 Theory and practice 31
Summary 32
Further reading 32
Review questions 33
Problem 33
Appendix: Formal derivation of the separation theorem 35
3 Financial (accounting) statements and
their interpretation 41
Objectives 41
3.1 Introduction 41
3.2 The financial statements 42
3.3 Definitions and conventions of accounting 46
3.4 Problems with using accounting information for
decision making 49
3.5 Creative accounting 50
3.6 Ratio analysis 53
3.7 Using accounting ratios to predict financial failure 66
Summary 67
Further reading 68
Relevant websites 68
Review questions 68
Problems 69
Appendix: Jackson plc’s income statement and balance
sheet for 2007 75
Part 2 Investment decisions
4 Investment appraisal methods 79
Objectives 79
4.1 Introduction 79
4.2 Net present value 80
4.3 Internal rate of return 87
4.4 Payback period 94
4.5 Accounting (unadjusted) rate of return 97
4.6 Investment appraisal methods used in practice 99
Summary 104
Further reading 105
Review questions 106
Problems 106
5 Practical aspects of investment appraisal 111
Objectives 111
5.1 Introduction 111
5.2 Cash flows or accounting flows? 112
5.3 Do cash flows really occur at year ends? 115
5.4 Which cash flows? 116
5.5 Taxation 117
5.6 Inflation 120
5.7 An example of an investment appraisal 121
5.8 Capital rationing 126
5.9 Replacement decisions 130
5.10 Routines for identifying, assessing, implementing and
reviewing investment projects 132
5.11 Investment appraisal and strategic planning 135
5.12 Value-based management 137
5.13 Real options 143
Summary 144
Further reading 146
Relevant website 146
Review questions 146
Problems 147
6 Risk in investment appraisal 153
Objectives 153
6.1 Introduction 153
6.2 Sensitivity analysis 154
6.3 Use of probabilities 159
6.4 Expected value 162
6.5 Systematic and specific risk 165
6.6 Utility theory 166
6.7 Attitudes to risk and expected value 169
6.8 Particular risks associated with making investments
overseas 174
6.9 Some evidence on risk analysis in practice 174
6.10 Risk – the story so far 174
Summary 175
Further reading 176
Review questions 177
Problems 177
7 Portfolio theory and its relevance to real
investment decisions 184
Objectives 184
7.1 The relevance of security prices 184
7.2 The expected value/variance (or mean/variance) criterion 186
7.3 Security investment and risk 187
7.4 Portfolio theory 189
7.5 Capital asset pricing model 198
7.6 CAPM: an example of beta estimation 200
7.7 Assumptions of CAPM 202
7.8 Tests of CAPM 202
7.9 CAPM – what went wrong? 203
7.10 How CAPM is used to derive discount rates for real
investments 204
7.11 Use of CAPM in practice 205
7.12 Arbitrage pricing model 205
7.13 Portfolio theory – where are we now? 206
Summary 208
Further reading 209
Review questions 209
Problems 210
Appendix: Derivation of CAPM 211
Part 3 Financing decisions
8 Sources of long-term finance 217
Objectives 217
8.1 Introduction 217
8.2 Ordinary (equity) capital 219
8.3 Methods of raising additional equity finance 223
8.4 Preference shares 232
8.5 Loan notes and debentures 234
8.6 Convertible loan notes 240
8.7 Warrants 240
8.8 Term loans 241
8.9 Asset-backed finance (securitisation) 241
8.10 Leasing 242
8.11 Grants from public funds 245
8.12 Conclusions on long-term finance 245
Summary 246
Further reading 249
Relevant websites 249
Review questions 249
Problems 250
9 The secondary capital market (the stock
exchange) and its efficiency 252
Objectives 252
9.1 Introduction 252
9.2 The London Stock Exchange 253
9.3 Capital market efficiency 256
9.4 Tests of capital market efficiency 259
9.5 The efficient market paradox 267
9.6 Conclusions on, and implications of, capital market
efficiency 267
Summary 270
Further reading 271
Review questions 272
Problems 272
10 Cost of capital estimations and the
discount rate 274
Objectives 274
10.1 Introduction 274
10.2 Cost of individual capital elements 275
10.3 Weighted average cost of capital ( WACC) 282
10.4 Practicality of using WACC as the discount rate 287
10.5 WACC values used in practice 288
Summary 289
Further reading 290
Review questions 291
Problems 291
11 Gearing, the cost of capital and shareholders’
wealth 294
Objectives 294
11.1 Introduction 294
11.2 Is debt finance as cheap as it seems? 295
11.3 Business risk and financial risk 296
11.4 The traditional view 299
11.5 The Modigliani and Miller view of gearing 300
11.6 Other thoughts on the tax advantage of debt financing 306
11.7 Capital/financial gearing and operating gearing 306
11.8 Other practical issues relating to capital gearing 307
11.9 Evidence on gearing 308
11.10 Gearing and the cost of capital – conclusion 310
11.11 The trade-off theory 312
11.12 Pecking order theory 313
11.13 Likely determinants of capital gearing 315
11.14 Weighted average cost of capital revisited 315
Summary 317
Further reading 318
Review questions 319
Problems 319
Appendix I: Proof of the MM cost of capital proposition (pre-tax) 323
Appendix II: Proof of the MM cost of capital proposition (after tax) 324
12 The dividend decision 326
Objectives 326
12.1 Introduction 326
12.2 Modigliani and Miller on dividends 327
12.3 The traditional view on dividends 329
12.4 Who is right about dividends? 330
12.5 Other factors 331
12.6 Dividends: the evidence 334
12.7 Conclusions on dividends 339
Summary 340
Further reading 341
Review questions 341
Problems 341
Appendix: Proof of the MM dividend irrelevancy proposition 345
Part 4 Integrated decisions
13 Management of working capital 349
Objectives 349
13.1 Introduction 349
13.2 The dynamics of working capital 350
13.3 The importance of the management of working capital 354
13.4 Working capital and liquidity 356
13.5 Overtrading 358
13.6 Inventories (stock in trade) 359
13.7 Just-in-time inventories management 366
13.8 Trade receivables (trade debtors or accounts receivable) 368
13.9 Cash (including overdrafts and short-term deposits) 372
13.10 Trade payables (trade creditors) 379
Summary 381
Further reading 383
Review questions 383
Problems 384
14 Corporate restructuring (including takeovers
and divestments) 387
Objectives 387
14.1 Introduction 387
14.2 Takeovers and mergers 388
14.3 Mergers: the practicalities 391
14.4 Divestments 400
Summary 403
Further reading 404
Relevant websites 404
Review questions 404
Problems 405
15 International aspects of business finance 408
Objectives 408
15.1 Introduction 408
15.2 Foreign exchange 411
15.3 Problems of internationalisation 418
15.4 International investment appraisal 425
15.5 Risks of internationalisation, management of those risks
and portfolio theory 427
Summary 429
Further reading 432
Review questions 432
Problems 432
16 Small businesses 434
Objectives 434
16.1 Introduction 434
16.2 Corporate objectives 437
16.3 Organisation of small businesses 438
16.4 Taxation of small businesses 438
16.5 Investment decisions 439
16.6 Risk and the discount rate 440
16.7 Sources of finance 441
16.8 Valuation of small businesses 444
16.9 Gearing 447
16.10 Dividends 448
16.11 Working capital and small businesses 448
Summary 449
Further reading 451
Relevant websites 451
Review questions 452
Problems 452
Appendix 1 Present value table 459
Appendix 2 Annuity table 460
Appendix 3 Suggested answers to review questions 461
Appendix 4 Suggested answers to selected problem questions 474
Glossary 500
References 506
Index 512