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Library of Congress Cataloging-in-Publication Data

Names: Vernimmen, Pierre, author.

Title: Corporate finance: theory and practice/Pierre Vernimmen, Pascal Quiry, Maurizio Dallocchio, Yann Le Fur, Antonio Salvi.

Description: Fifth edition. | Hoboken: Wiley, 2017. | Revised edition of Corporate finance, 2014. | Includes index. |

Identifiers: LCCN 2017030393 (print) | LCCN 2017033170 (ebook) | ISBN 9781119451808 (pdf) | ISBN 9781119424529 (epub) | ISBN 9781119424482 (paperback)

Subjects: LCSH: Corporations–Finance. | Business enterprises–Finance. |

BISAC: BUSINESS & ECONOMICS/Corporate Finance.

Classification: LCC HG4026 (ebook) | LCC HG4026 .V467 2017 (print) | DDC 658.15–dc23

LC record available at https://lccn.loc.gov/2017030393

A catalogue record for this book is available from the British Library.

ISBN 978-1-119-42448-2 (paperback) ISBN 978-1-119-45180-8 (ebk)

ISBN 978-1-119-42452-9 (ebk) ISBN 978-1-119-42444-4 (ebk)

Cover design: Wiley

Cover Image: © liravega/Shutterstock

Contents

About the Authors

Preface

Frequently used symbols

Chapter 1: What is corporate finance?

Section 1.1 The financial manager is first and foremost a salesman . . .
Section 1.2 . . . of financial securities . . .
Section 1.3 . . . valued continuously by the financial markets
Section 1.4 Most importantly, he is a negotiator . . .
Section 1.5 . . . who never forgets to do an occasional reality check!
Section 1.6 . . . he is also now a risk manager

Section I: Financial analysis

Part One: Fundamental concepts in financial analysis
1. Chapter 2: Cash flow
  1. Section 2.1 Classifying company cash flows
  2. Section 2.2 Operating and investment cycles
  3. Section 2.3 Financial resources
2. Chapter 3: Earnings
  1. Section 3.1 Additions to wealth and deductions from wealth
  2. Section 3.2 Different income statement formats
3. Chapter 4: Capital employed and invested capital
  1. Section 4.1 The balance sheet: definitions and concepts
  2. Section 4.2 A capital-employed analysis of the balance sheet
  3. Section 4.3 A solvency-and-liquidity analysis of the balance sheet
  4. Section 4.4 A detailed example of a capital-employed balance sheet
4. Chapter 5: Walking through from earnings to cash flow
  1. Section 5.1 Analysis of earnings from a cash flow perspective
  2. Section 5.2 Cash flow statement
5. Chapter 6: Getting to grips with consolidated accounts
  1. Section 6.1 Consolidation methods
  2. Section 6.2 Consolidation-related issues
  3. Section 6.3 Technical aspects of consolidation
6. Chapter 7: How to cope with the most complex points in financial accounts
  1. Section 7.1 Accruals
  2. Section 7.2 Cash assets
  3. Section 7.3 Construction contracts
  4. Section 7.4 Convertible bonds and loans
  5. Section 7.5 Currency translation adjustments
  6. Section 7.6 Deferred tax assets and liabilities
  7. Section 7.7 Dilution profit and losses
  8. Section 7.8 Financial hedging instruments
  9. Section 7.9 Impairment losses
  10. Section 7.10 Intangible fixed assets
  11. Section 7.11 Inventories
  12. Section 7.12 Leases
  13. Section 7.13 Off-balance-sheet commitments
  14. Section 7.14 Pensions and other employee benefits
  15. Section 7.15 Preference shares
  16. Section 7.16 Provisions
  17. Section 7.17 Stock options
  18. Section 7.18 Tangible assets
  19. Section 7.19 Treasury shares
Part Two: Financial analysis and forecasting
1. Chapter 8: How to perform a financial analysis
  1. Section 8.1 What is financial analysis?
  2. Section 8.2 Economic analysis of companies
  3. Section 8.3 An assessment of a company’s accounting policy
  4. Section 8.4 Standard financial analysis plan
  5. Section 8.5 The various techniques of financial analysis
  6. Section 8.6 Ratings
  7. Section 8.7 Scoring techniques
  8. Section 8.8 Expert systems
2. Chapter 9: Margin analysis: structure
  1. Section 9.1 How operating profit is formed
  2. Section 9.2 How operating profit is allocated
  3. Section 9.3 Standard income statements (individual and consolidated accounts)
  4. Section 9.4 Financial assessment
  5. Section 9.5 Case study: ArcelorMittal
3. Chapter 10: Margin analysis: risks
  1. Section 10.1 How operating leverage works
  2. Section 10.2 A more refined analysis provides greater insight
  3. Section 10.3 From analysis to forecasting: the concept of normative margin
  4. Section 10.4 Case study: ArcelorMittal
4. Chapter 11: Working capital and capital expenditures
  1. Section 11.1 The nature of working capital
  2. Section 11.2 Working capital turnover ratios
  3. Section 11.3 Reading between the lines of working capital
  4. Section 11.4 Analysing capital expenditures (capex)
  5. Section 11.5 Case study: ArcelorMittal
5. Chapter 12: Financing
  1. Section 12.1 A dynamic analysis of the company’s financing
  2. Section 12.2 A static analysis of the company’s financing
  3. Section 12.3 Case study: ArcelorMittal
6. Chapter 13: Return on capital employed and return on equity
  1. Section 13.1 Analysis of corporate profitability
  2. Section 13.2 Leverage effect
  3. Section 13.3 Uses and limitations of the leverage effect
  4. Section 13.4 Case study: ArcelorMittal
7. Chapter 14: Conclusion of financial analysis
  1. Section 14.1 Solvency
  2. Section 14.2 Value creation
  3. Section 14.3 Financial analysis without the relevant accounting documents
  4. Section 14.4 Case study: ArcelorMittal

Section II: Investors and markets

Part One: Investment decision rules
1. Chapter 15: The financial markets
  1. Section 15.1 The rise of capital markets
  2. Section 15.2 The functions of a financial system
  3. Section 15.3 The relationship between banks and companies
  4. Section 15.4 Theoretical framework: efficient markets
  5. Section 15.5 Another theoretical framework under construction: behavioural finance
  6. Section 15.6 Investors’ behaviour
2. Chapter 16: The time value of money and net present value
  1. Section 16.1 Capitalisation
  2. Section 16.2 Discounting
  3. Section 16.3 Present value and net present value of a financial security
  4. Section 16.4 What does net present value depend on?
  5. Section 16.5 Some examples of simplification of present value calculations
3. Chapter 17: The internal rate of return
  1. Section 17.1 How is internal rate of return determined?
  2. Section 17.2 Internal rate of return as an investment criterion
  3. Section 17.3 The limits of the internal rate of return
  4. Section 17.4 Some more financial mathematics: interest rate and yield to maturity
Part Two: The risk of securities and the required rate of return
1. Chapter 18: Risk and return
  1. Section 18.1 Sources of risk
  2. Section 18.2 Risk and fluctuation in the value of a security
  3. Section 18.3 Tools for measuring return and risk
  4. Section 18.4 Market and specific risk
  5. Section 18.5 The beta coefficient
  6. Section 18.6 Portfolio risk
  7. Section 18.7 Choosing among several risky assets and the efficient frontier
  8. Section 18.8 Choosing between several risky assets and a risk-free asset: the capital market line
  9. Section 18.9 How portfolio management works
2. Chapter 19: The required rate of return
  1. Section 19.1 Return required by investors: the CAPM
  2. Section 19.2 Properties of the CAPM
  3. Section 19.3 Limits of the CAPM
  4. Section 19.4 Multifactor models
  5. Section 19.5 Fractals and other leads
  6. Section 19.6 Term structure of interest rates
Part Three: Financial securities
1. Chapter 20: Bonds
  1. Section 20.1 Basic concepts
  2. Section 20.2 The yield to maturity
  3. Section 20.3 Floating-rate bonds
  4. Section 20.4 Socially responsible bonds
  5. Section 20.5 The volatility of debt securities
  6. Section 20.6 Default risk and the role of rating
2. Chapter 21: Other debt products
  1. Section 21.1 Marketable debt securities
  2. Section 21.2 Bank debt products
  3. Section 21.3 Financing linked to an asset of the firm
3. Chapter 22: Shares
  1. Section 22.1 Basic concepts
  2. Section 22.2 Multiples
  3. Section 22.3 Key market data
  4. Section 22.4 How to perform a stock market analysis
  5. Section 22.5 Adjusting per share data for technical factors
4. Chapter 23: Options
  1. Section 23.1 Definition and theoretical foundation of options
  2. Section 23.2 Mechanisms used in pricing options
  3. Section 23.3 Analysing options
  4. Section 23.4 Parameters to value options
  5. Section 23.5 Methods for pricing options
  6. Section 23.6 Tools for managing an options position
5. Chapter 24: Hybrid securities
  1. Section 24.1 Warrants
  2. Section 24.2 Convertible bonds
  3. Section 24.3 Preference shares
  4. Section 24.4 Other hybrid securities
6. Chapter 25: Selling securities
  1. Section 25.1 General principles in the sale of securities
  2. Section 25.2 Initial public offerings
  3. Section 25.3 Capital increases
  4. Section 25.4 Block trades of shares
  5. Section 25.5 Bonds
  6. Section 25.6 Convertible and exchangeable bonds
  7. Section 25.7 Syndicated loans

Section III: Value

Chapter 26: Value and corporate finance
1. Section 26.1 The purpose of finance is to create value
2. Section 26.2 Value creation and markets in equilibrium
3. Section 26.3 Value and organisation theories
4. Section 26.4 How can we create value?
5. Section 26.5 Value and taxation
Chapter 27: Measuring value creation
1. Section 27.1 Overview of the different criteria
2. Section 27.2 NPV, the only reliable criterion
3. Section 27.3 Financial/accounting criteria
4. Section 27.4 Market criteria
5. Section 27.5 Accounting criteria
6. Section 27.6 Putting things into perspective
Chapter 28: Investment criteria
1. Section 28.1 The predominance of NPV and the importance of IRR
2. Section 28.2 The main lines of reasoning
3. Section 28.3 Which cash flows are important?
4. Section 28.4 Other investment criteria
Chapter 29: The cost of capital
1. Section 29.1 The cost of capital and the risk of assets
2. Section 29.2 Alternative methods for estimating the cost of capital
3. Section 29.3 Some practical applications
4. Section 29.4 Can corporate managers influence the cost of capital?
Chapter 30: Risk and investment analysis
1. Section 30.1 Assessing risk through the business plan
2. Section 30.2 Assessing risk through a mathematical approach
3. Section 30.3 The contribution of real options
Chapter 31: Valuation techniques
1. Section 31.1 Overview of the different methods
2. Section 31.2 Valuation by discounted cash flow
3. Section 31.3 Multiple approach or peer-group comparisons
4. Section 31.4 The sum-of-the-parts method (SOTP) or net asset value (NAV)
5. Section 31.5 Comparison of valuation methods
6. Section 31.6 Premiums and discounts

Section IV: Corporate financial policies

Part One: Capital structure policies
1. Chapter 32: Capital structure and the theory of perfect capital markets
  1. Section 32.1 The value of capital employed
  2. Section 32.2 Debt and equity
  3. Section 32.3 What our grandparents thought
  4. Section 32.4 The capital structure policy in perfect financial markets
2. Chapter 33: Capital structure, taxes and organisation theories
  1. Section 33.1 The benefits of debt or the trade-off model
  2. Section 33.2 Debt to control management
  3. Section 33.3 Signalling and debt policy
  4. Section 33.4 Information asymmetries and the pecking order theory
3. Chapter 34: Debt, equity and options theory
  1. Section 34.1 Analysing the firm in light of options theory
  2. Section 34.2 Contribution of options theory to the valuation of equity
  3. Section 34.3 Using options theory to analyse a company’s financial decisions
  4. Section 34.4 Resolving conflicts between shareholders and creditors
  5. Section 34.5 Analysing the firm’s liquidity
  6. Section 34.6 Conclusion
4. Chapter 35: Working out details: the design of the capital structure
  1. Section 35.1 The major concepts
  2. Section 35.2 How to choose a capital structure
  3. Section 35.3 Effects of the financing choice on accounting and financial criteria
Part Two: Equity capital
1. Chapter 36: Returning cash to shareholders
  1. Section 36.1 Reinvested cash flow and the value of equity
  2. Section 36.2 Internal financing and financial criteria
  3. Section 36.3 Why return cash to shareholders?
2. Chapter 37: Distribution in practice: dividends and share buy-backs
  1. Section 37.1 Dividends
  2. Section 37.2 Exceptional dividends, share buy-backs and capital reduction
  3. Section 37.3 The choice between dividends, share buy-backs and capital reduction
3. Chapter 38: Share issues
  1. Section 38.1 A definition of a share issue
  2. Section 38.2 Share issues and finance theory
  3. Section 38.3 Current and new shareholders
  4. Section 38.4 Share issues and accounting criteria
Part Three: Debt capital
1. Chapter 39: Implementing a debt policy
  1. Section 39.1 Debt structure
  2. Section 39.2 Covenants
  3. Section 39.3 Renegotiating debt
  4. Section 39.4 Why keep cash on the balance sheet?
  5. Section 39.5 The levers of a good debt policy

Section V: Financial management

Part One: Corporate governance and financial engineering
1. Chapter 40: Setting up a company or financing start-ups
  1. Section 40.1 Financial particularities of the company being set up
  2. Section 40.2 Some basic principles for financing a start-up
  3. Section 40.3 Investors in start-ups
  4. Section 40.4 The organisation of relationships between the entrepreneur and the financial investors
  5. Section 40.5 The financial management of a start-up
  6. Section 40.6 The particularities of valuing young companies
  7. Section 40.7 Example inspired by a real case: Example.com
2. Chapter 41: Choice of corporate structure
  1. Section 41.1 Shareholder structure
  2. Section 41.2 How to strengthen control over a company
  3. Section 41.3 Organising a diversified group
  4. Section 41.4 Financial securities’ discounts
3. Chapter 42: Initial public offerings (IPOs)
  1. Section 42.1 To be or not to be listed?
  2. Section 42.2 Preparation of an IPO
  3. Section 42.3 Execution of the IPO
  4. Section 42.4 Underpricing of IPOs
  5. Section 42.5 How to carry out a successful IPO
  6. Section 42.6 Public to private
4. Chapter 43: Corporate governance
  1. Section 43.1 What does corporate governance mean?
  2. Section 43.2 Corporate governance and financial theories
  3. Section 43.3 Value and corporate governance
5. Chapter 44: Taking control of a company
  1. Section 44.1 The rise of mergers and acquisitions
  2. Section 44.2 Choosing a negotiating strategy
  3. Section 44.3 Taking over a listed company
6. Chapter 45: Mergers and demergers
  1. Section 45.1 All-share deals
  2. Section 45.2 The mechanics of all-share transactions
  3. Section 45.3 Demergers and split-offs
7. Chapter 46: Leveraged buyouts (LBOs)
  1. Section 46.1 LBO structures
  2. Section 46.2 The players
  3. Section 46.3 LBOs and financial theory
  4. Section 46.4 The LBO market: following the crisis, a gradual bounce-back
8. Chapter 47: Bankruptcy and restructuring
  1. Section 47.1 Causes of bankruptcy
  2. Section 47.2 The different bankruptcy procedures
  3. Section 47.3 Bankruptcy and financial theory
  4. Section 47.4 Restructuring plans
Part Two: Managing working capital, cash flows, financial risks and real estate
1. Chapter 48: Managing working capital
  1. Section 48.1 A bit of common sense
  2. Section 48.2 Managing receivables
  3. Section 48.3 Managing trade payables
  4. Section 48.4 Inventory management
  5. Section 48.5 Conclusion
2. Chapter 49: Cash management
  1. Section 49.1 The basics
  2. Section 49.2 Cash management
  3. Section 49.3 Cash management within a group
  4. Section 49.4 Investing cash balances
  5. Section 49.5 The changing role of the treasurer
3. Chapter 50: Managing financial risks
  1. Section 50.1 Introduction to risk management
  2. Section 50.2 Measuring financial risks
  3. Section 50.3 Principles of financial risk management
  4. Section 50.4 Organised markets – OTC markets
4. Chapter 51: Managing operational real estate
  1. Section 51.1 Methods for financing real estate
  2. Section 51.2 Criteria for choosing real-estate financing
  3. Section 51.3 Value creation and investor perception
  4. Section 51.4 An ideal way of organising real estate?

Epilogue – Finance and Strategy

Top 20 Largest Listed Companies

Contents

Index

EULA

Preface

This book aims to cover the full scope of corporate finance as it is practised today worldwide.

A way of thinking about finance

We are very pleased with the success of the first three editions of the book. It has encouraged us to retain the approach in order to explain corporate finance to students and professionals. There are four key features that distinguish this book from the many other corporate finance textbooks available on the market today:

Our strong belief that financial analysis is part of corporate finance. Pierre Vernimmen, who was mentor and partner to some of us in the practice of corporate finance, understood very early on that a good financial manager must first be able to analyse a company’s economic, financial and strategic situation, and then value it, while at the same time mastering the conceptual underpinnings of all financial decisions.
Corporate Finance is neither a theoretical textbook nor a practical workbook. It is a book in which theory and practice are constantly set off against each other, in the same way as in our daily practice as investors at Monestier Capital, DGPA and Natixis, as board members of several listed and unlisted companies, and as teachers at HEC Paris and Bocconi business schools.
Emphasis is placed on concepts intended to give you an understanding of situations, rather than on techniques, which tend to shift and change over time. We confess to believing that the former will still be valid in 20 years’ time, whereas the latter will, for the most part, be long forgotten!
Financial concepts are international, but they are much easier to grasp when they are set in a familiar context. We have tried to give examples and statistics from all around the world to illustrate the concepts.

The five sections

This book starts with an introductory chapter reiterating the idea that corporate financiers are the bridge between the economy and the realm of finance. Increasingly, they must play the role of marketing managers and negotiators. Their products are financial securities that represent rights to the firm’s cash flows. Their customers are bankers and investors. A good financial manager listens to customers and sells them good products at high prices. A good financial manager always thinks in terms of value rather than costs or earnings.

Section I goes over the basics of financial analysis, i.e. understanding the company based on a detailed analysis of its financial statements. We are amazed at the extent to which large numbers of investors neglected this approach during the latest stock-market euphoria. When share prices everywhere are rising, why stick to a rigorous approach? For one thing, to avoid being caught in the crash that inevitably follows.

The return to reason has also returned financial analysis to its rightful place as a cornerstone of economic decision-making. To perform financial analysis, you must first understand the firm’s basic financial mechanics (Chapters 2–5). Next you must master the basic techniques of accounting, including accounting principles, consolidation techniques and certain complexities (Chapters 6 and 7), based on international (IFRS) standards now mandatory in over 80 countries, including the EU (for listed companies), Australia, South Africa and accepted by the SEC for US listing. In order to make things easier for the newcomer to finance, we have structured the presentation of financial analysis itself around its guiding principle: in the long run, a company can survive only if it is solvent and creates value for its shareholders. To do so, it must generate wealth (Chapters 9 and 10), invest (Chapter 11), finance its investments (Chapter 12) and generate a sufficient return (Chapter 13). The illustrative financial analysis of the Italian appliance manufacturer Indesit will guide you throughout this section of the book.

Section II reviews the basic theoretical knowledge you will need to make an assessment of the value of the firm. Here again, the emphasis is on reasoning, which in many cases will become automatic (Chapters 15–19): efficient capital markets, the time value of money, the price of risk, volatility, arbitrage, return, portfolio theory, present value and future value, market risk, beta, etc. Then we review the major types of financial securities: equity, debt and options, for the purposes of valuation, along with the techniques for issuing and placing them (Chapters 20–25).

Section III is devoted to value, to its theoretical foundations and to its computation. Value is the focus of any financier, both its measure and the way it is shared. Over the medium term, creating value is, most of the time, the first aim of managers (Chapters 26–31).

In Section IV, “Corporate financial policies”, we analyse each financial decision in terms of:

value in the context of the theory of efficient capital markets;
balance of power between owners and managers, shareholders and debtholders (agency theory);
communication (signal theory).

Such decisions include choosing a capital structure, investment decisions, cost of capital, dividend policy, share repurchases, capital increases, hybrid security issues, etc.

In this section, we draw your attention to today’s obsession with earnings per share, return on equity and other measures whose underlying basis we have a tendency to forget and which may, in some cases, be only distantly related to value creation. We have devoted considerable space to the use of options (as a technique or a type of reasoning) in each financial decision (Chapters 32–39).

When you start reading Section V, “Financial management”, you will be ready to examine and take the remaining decisions: how to create and finance a start-up, how to organise a company’s equity capital and its governance, buying and selling companies, mergers, demergers, LBOs, bankruptcy and restructuring (Chapters 40–47). Lastly, this section presents working capital management, cash management, the management of the firm’s financial risks and its operational real-estate assets (Chapters 48–51).

Last but not least, the epilogue addresses the question of the links between finance and strategy.

Suggestions for the reader

To make sure that you get the most out of your book, each chapter ends with a summary and a series of problems and questions (over 800 with the solutions provided). We’ve used the last page of the book to provide a crib sheet (the nearly 1000 pages of this book summarised on one page!). For those interested in exploring the topics in greater depth, there is an end-of-chapter bibliography and suggestions for further reading, covering fundamental research papers, articles in the press, published books and websites. A large number of graphs and tables (over 100!) have been included in the body of the text and these can be used for comparative analyses. Finally, there is a fully comprehensive index.

The masculine pronoun has been used throughout this book simply for convenience and brevity. This use is not intended to be discriminatory in any way.

An Internet site with huge and diversified content

www.vernimmen.com provides free access to tools (formulas, tables, statistics, lexicons, glossaries), resources that supplement the book (articles, prospectuses of financial transactions, financial figures for over 16 000 European, North American and emerging countries, listed companies, thesis topics, thematic links, a list of must-have books for your bookshelf, an Excel file providing detailed solutions to all of the problems set in the book), plus problems, case studies and quizzes for testing and improving your knowledge. There is a letterbox for your questions to the authors (we reply within 72 hours, unless, of course, you manage to stump us!). There are questions and answers and much more. The site has its own internal search engine, and new services are added regularly.

A teachers’ area provides teachers with free access to case studies, slides and an Instructor’s Manual, which gives advice and ideas on how to teach all of the topics discussed in the book.

A free monthly newsletter on corporate finance

Since (unfortunately) we can’t bring out a new edition of this book every month, we have set up the Vernimmen.com Newsletter, which is sent out free of charge to subscribers via the web. It contains:

A conceptual look at a topical corporate finance problem (e.g. accounting for operating and capital leases, financially managing during a deflation phase).
Statistics and tables that you are likely to find useful in the day-to-day practice of corporate finance (e.g. corporate income tax rates, debt ratios in LBOs).
A critical review of a financial research paper with a concrete dimension (e.g. The real effect of corporate cash, why don’t US issuers demand European fees for their IPOs?).
A question left on the vernimmen.com site by a visitor plus a response (e.g. Why do successful groups have such a low debt level? What is an assimilation clause?).

Subscribe to www.vernimmen.com and become one of the many readers of the Vernimmen.com Newsletter.

And lastly a Facebook page

We publish daily comments on financial news that we deem to be of interest, answer questions from web users and publish finance- and business-related quotes. These could come in useful when preparing for a job interview or serve as food for thought for those of you wanting to take time out and think about what’s going on in the corporate and financial world.

Many thanks

To Patrice Carlean-Jones, William Crawford, Matthew Cush, Nicolas Elissalde, Pierre Elliot Finel, Simon Gueguen, Arnaud Jacquillat, Robert Killingsworth, Louis Lefebvre, Franck Megel, Agnès Melot, François Meunier, Pascale Mourvillier, John Olds, Claire Quiry, Paul Quiry, Gita Roux, Steven Sklar and students of the HEC Paris and Bocconi MBA programmes for their help in improving the manuscript.
To Gemma Valler our editor.
To Altimir Perrody, the vernimmen.com webmaster.
And last but not least to Françoise, Anne-Valérie, Enrica and Anastasia; our children Paul, Claire, Pierre, Philippe, Soazic, Solène, Aymeric and Maria Letizia; our many friends who have had to endure our endless absences over the last years; and of course Catherine Vernimmen and her children for their everlasting and kind support.

We hope that you will gain as much enjoyment from your copy of this book – whether you are a new student of corporate finance or are using it to revise and hone your financial skills – as we have had in editing this edition and in expanding the services and products that go with it.

We wish you well in your studies!

Pascal Quiry

Yann Le Fur

Paris, July 2017

Maurizio Dallocchio

Antonio Salvi