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Pierre Vernimmen

Corporate

Finance

Theory and Practice

Pascal Quiry

Maurizio Dallocchio

Yann Le Fur

Antonio Salvi

Corporate Finance

This book is unique ... one of the ultimate study and reference guides for European “nanciers from students

to CFOs. The French-language versions of theVernimmenhave been for me some of the most helpful and trusted companions throughout my professional career. Dan Arendt, Corporate Finance partner at Deloitte in Luxembourg

This book is particularly useful for those people who look for the bridge between strategic, operational and investment

decisions on one hand, and “nancial accounts on the other. The authors approach, which consists of guiding the reader

from “nancial accounting to most complex deals that have strategic implications for “rms, is new and very useful. I would

recommend this book to those who want to succeed in both the in-house and the external consulting world, as well as in

the area of Corporate Finance. Stephan Dertnig, Vice President, Moscow Oce, The Boston Consulting Group

Im glad to hear that Vernimmens unique book on “nance is now available for English-speaking readers. I have known

this excellent book for many years, which all professionals can easily use when they need to go back to the basics of

modern Corporate Finance. Smartly written, thorough, lively, and regularly updated. I strongly recommend it to everyone ...

from the debutant in “nance to high-level experts. Learning withVernimmenis a real pleasure.

Antoine Giscard dEstaing, CFO of Danone

VernimmensCorporate Finance, long overdue in English, is an outstandingly clear and complete manual, a wonderful

merger of practice and theory. Its coverage of the market aspects of Corporate Finance and of European practices

distinguishes its content, but its treatment of all the material makes it essential reading for the student, “nancier or

industrialist.

¨d Business School, Oxford University, UK

This book was the “rst “nance book I read as a student in my twenties. I read it again in my thirties to review some of the

key “nance challenges I was facing in my professional life. Now, in my forties, I am reviewing it once more to compare the

reality I have to face now in Asia, with the most advanced “nancial concepts. I have never been disappointed and have

always been able to “nd the appropriate answer to my questions, as well as food for thought. I am sure my children will

read it when I am in my “fties, asVernimmenis not just another book on “nance: this is “nance as a life experiment.

I strongly recommend this book to all the corporate managers facing new questions or challenges in their professional

lives, especially in an international multi-currency context. You do not need to be a “nance expert to enjoy reading it, as

its really easy to understand, with enough explanations, concrete examples...and humour, to help you jump successfully

into the most sophisticated theories. But, if you are an expert, you will also “nd food for thought, as its methodological

bases are strong enough to satisfy the most demanding CFO. Jean-Michel Moutin, CFO, Louis Vuitton Asia Paci“c-Japan

Understanding Corporate Finance is key to successful company management. From a bankers point of view, a good

understanding of Corporate Finance is crucial to assist a company. TheVernimmen, written for Europeans by Europeans is

a most useful reference for the student as well as the practitioner. The style of the book is concise, yet every conceivable

aspect of Corporate Finance is covered. Complemented by an exhaustive website containing summaries of key concepts, of

formulae, and of “nancial statements from a wide range of companies, theVernimmenis a must. Michael Rockinger, Professor of Finance, Director of the Institute of Banking and Finance,

HEC & FAME, University of Lausanne, Switzerland

This book eciently bridges “nancial theory and practice, and encapsulates everything a Corporate Finance banker will

ever need to know and understand. It is obvious that the authors are passionate about “nance, and their enthusiasm is

contagious. Written in an easy and accessible style, this book deserves to become a reference work. Jan Zarzycki, Director, Equity Capital Markets, Deutsche Bank

Pierre Vernimmen

Corporate

Finance

Theory and Practice

Pascal Quiry

Maurizio Dallocchio

Yann Le Fur

Antonio Salvi

Copyright#2005 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,

West Sussex PO19 8SQ, England

Telephone: (þ44) 1243 779777

Email (for orders and customer service enquiries): cs-books@wiley.co.uk

Visit our Home Page onwww.wiley.com

All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or emailed to permreq@wiley.co.uk, or faxed to (þ44) 1243 770620. Adapted and updated from the original French, “rst published by E

´ditions Dalloz, Paris, 1994

(sixth edition 2005). Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or

registered trademarks of their respective owners. The Publisher is not associated with any product or

vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the Publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought.

Other Wiley Editorial Of“ces

John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA Wiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1 Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books.

British Library Cataloguing in Publication Data

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

ISBN-13 978-0-470-09225-5 (PB)

ISBN-10 0-470-09225-4 (PB)

Project management by Originator, Gt Yarmouth, Norfolk (typeset in 10/12pt Times and Meta) Printed and bound in Great Britain by Scotprint, Haddington, Scotland This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production.

About the authors

Pascal Quiryis an adjunct “nance teacher in the leading French business school HEC Paris, and a managing director at BNP Paribas Corporate Finance, specialising in M&A transactions for listed companies. Maurizio Dallocchiois the current Dean of the leading Italian business school Bocconi (Milan) and Lehman Brothers Chair of Corporate Finance. He is also a board member of several listed and unlisted companies and is one of the most distinguished Italian authorities on “nance. Yann Le Furis a corporate “nance teacher at HEC Paris business school and an investment banker with Mediobanca in Paris (after several years with Schroders and Citigroup). Antonio Salviis an Assistant Professor of Finance at Bocconi and the University of Venice where he teaches Corporate Finance. His areas of research cover cost of capital, structure of debt “nance and corporate governance. Pierre Vernimmen, who died in 1996, was both an M&A dealmaker (he advised

Louis Vuitton on its merger with Moe

¨t Henessy to create LVMH, the world luxury

goods leader) and a “nance teacher at HEC Paris. His book,Finance d"Entreprise, was and still is the top-selling “nancial textbook in French-speaking countries and is the forebear ofCorporate Finance: Theory and Practice. The authors of this book wish to express their profound thanks to the HEC Paris Business School and Foundation, ABN Amro, Barclays, BNP Paribas, DGPA, HSBC, Lazard, and Nomura for their generous “nancial support; also Matthew Cush, Robert Killingsworth, John Olds, Gita Roux, Steven Sklar and Patrice Carlean-Jones who helped us tremendously in writing this book.

Summary

Foreword by Richard Rollxvi

Prefacexviii

List of frequently used symbolsxxii

1What is corporate finance?1

Section I

Financial analysis

15

Part One

Fundamental concepts infinancial analysis

17

2Cash flows19

3Earnings29

4Capital employed and invested

capital 44

5Walking through from earnings tocash flow

57

6Getting to grips with consolidatedaccounts

73

7How to cope with the most complexpoints in financial accounts

94

Part Two

Financial analysis andforecasting

121

8How to perform a financial

analysis 123

9Margin analysis: Structure155

10Margin analysis: Risks178

11Working capital and capitalexpenditures

193

12Financing217

13Return on capital employed and

return on equity 232

14Conclusion of financial analysis252

Section II

Investment analysis

259

Part One

Investment decision rules

261

15The financial markets263

16The time value of money and Net

Present Value (NPV)

290

17The Internal Rate of Return (IRR)309

18Incremental cash flows and otherinvestment criteria

327

19Measuring value creation345

20Risk and investment analysis367

Part Two

The risk of securities and thecost of capital

385

21Risk and return387

vii

22The cost of equity419

23From the cost of equity to the

cost of capital 443

24The term structure of interest

rates 461

Section III

Corporate financialpolicies

473

Part One

Financial securities

475

25Enterprise value and financial

securities 477

26Debt securities485

27Managing net debt512

28Shares538

29Options556

30Hybrid securities577

31Selling securities601

Part Two

Capital structure policies

635

32Value and corporate finance637

33Capital structure and the theory

of perfect capital markets 657

34The tradeoff model668

35Debt, equity and options theory698

36Working out details: The design

of the capital structure 716

Part Three

Equity capital and dividendpolicies

753

37Internal financing: Reinvesting cash

flow 755

38Returning cash to shareholders:Dividend policies

768

39Capital increases792

Section IV

Financial management

809

Part One

Valuation and financialengineering

811

40Valuation813

41Choice of corporate structure844

42Taking control of a company873

43Mergers and demergers894

44Leveraged buyouts (LBOs)912

45Bankruptcy and restructuring923

Part Two

Managing net debt andfinancial risks

937

46Managing cash flows939

47Asset-based financing956

48Managing financial risks972

Glossary992

Index1002

Vernimmen.com1031

Cribsheet1032Summary

Contents

Foreword by Richard Rollxvi

Prefacexviii

List of frequently used symbolsxxii

1 What is corporate finance?1

1.1 The financial manager is first and foremost a salesman...1

1.2...of financial securities...4

1.3...valued continuously in the financial markets7

1.4 Most importantly, he is a negotiator...10

1.5...and he remembers to do an occasional reality check!11

Section I Financial analysis15

Part One Fundamental concepts in financial analysis17

2 Cash flows19

2.1 Operating and investment cycles20

2.2 Financial resources22

3 Earnings29

3.1 Additions to wealth and deductions to wealth29

3.2 Different income statement formats34

4 Capital employed and invested capital44

4.1 The balance sheet: definitions and concepts45

4.2 The capital-employed analysis of the balance sheet47

4.3 A solvency-and-liquidity analysis of the balance sheet51

4.4 A detailed example of a capital-employed balance sheet53

5 Walking through from earnings to cash flow57

5.1 Analysis of earnings from a cash flow perspective57

5.2 Cash flow statement61

6 Getting to grips with consolidated accounts73

6.1 Consolidation methods73

6.2 Consolidation-related issues80

6.3 Technical aspects of consolidation85

7 How to cope with the most complex points in financial accounts94

7.1 Accruals95

7.2 Construction contracts95

7.3 Convertible bonds and loans96

7.4 Currency translation adjustments97

7.5 Deferred tax assets and liabilities97

7.6 Dilution profit and losses99

7.7 Exchangeable bonds100

7.8 Goodwill100

7.9 Intangible fixed assets101

7.10 Inventories104

7.11 Leases106

7.12 Mandatory convertible bonds108

7.13 Off-balance-sheet commitments108

7.14 Preference shares110

7.15 Perpetual subordinated loans and notes111

7.16 Provisions111

7.17 Stock options115

7.18 Tangible fixed assets116

7.19 Treasury shares117

Part Two Financial analysis and forecasting121

8 How to perform a financial analysis123

8.1 What is financial analysis?123

8.2 Economic analysis of companies125

8.3 An assessment of a companys accounting policy137

8.4 Standard financial analysis plan138

8.5 The various techniques of financial analysis139

8.6 Ratings142

8.7 Scoring techniques143

8.8 Expert systems144

9 Margin analysis: Structure155

9.1 How operating profit is formed156

9.2 How operating profit is allocated166

9.3 Financial assessment167

9.4 Pro forma income statements (individual and consolidated accounts)172

9.5 Case study: Ericsson172

10 Margin analysis: Risks178

10.1 How operating leverage works178

10.2 A more refined analysis provides greater insight182

10.3 From analysis to forecasting: the concept of normative margin187

10.4 Case study: Ericsson188

11 Working capital and capital expenditures193

11.1 The nature of working capital193

11.2 Working capital turnover ratios197

ix

Contents

11.3 Reading between the lines of working capital201

11.4 Analysing capital expenditures207

11.5 Case study: Ericsson210

12 Financing217

12.1 A dynamic analysis of the companys financing218

12.2 A static analysis of the companys financing220

12.3 Case study: Ericsson227

13 Return on capital employed and return on equity232

13.1 Analysis of corporate profitability232

13.2 Leverage effect234

13.3 Uses and limitations of the leverage effect243

13.4 Case study: Ericsson246

14 Conclusion of financial analysis252

14.1 Solvency252

14.2 Value creation254

14.3 Financial analysis without the relevant accounting documents255

14.4 Case study: Ericsson256

Section II Investment analysis259

Part One Investment decision rules261

15 The financial markets263

15.1 The rise of capital markets263

15.2 The functions of a financial system268

15.3 The relationship between banks and companies270

15.4 From value to price (1): financial communication271

15.5 From value to price (2): efficient markets272

15.6 Limitations in the theory of efficient markets277

15.7 Investors behaviour282

16 The time value of money and Net Present Value (NPV)290

16.1 Capitalisation290

16.2 Discounting294

16.3 Present value and net present value of a financial security296

16.4 The NPV decision rule297

16.5 What does net present value depend on?298

16.6 Some examples of simplification of present value calculations299

16.7 Special NPV topics302

17 The Internal Rate of Return (IRR)309

17.1 How is internal rate of return determined?309

17.2 Internal rate of return as an investment criterion310

17.3 The limits of the internal rate of return310

17.4 Some more financial mathematics: interest rate and yield to maturity317

x

Contents

18 Incremental cash flows and other investment criteria327

18.1 The predominance of NPV and the importance of IRR327

18.2 The main lines of reasoning329

18.3 Which cash flows are important?333

18.4 Other investment criteria334

19 Measuring value creation345

19.1 Accounting criteria348

19.2 Economic criteria353

19.3 Market criteria357

19.4 Putting things into perspective359

20 Risk and investment analysis367

20.1 A closer look at risk368

20.2 The contribution of real options373

Part Two The risk of securities and the cost of capital385

21 Risk and return387

21.1 Sources of risk387

21.2 Risk and fluctuation in the value of a security389

21.3 Tools for measuring return and risk392

21.4 How diversification reduces risk394

21.5 Portfolio risk396

21.6 Measuring how individual securities affect portfolio risk:

the beta coefficient401

21.7 Choosing among several risky assets and the efficient frontier405

21.8 Choosing between several risky assets and a risk-free asset:

the capital market line407

21.9 How portfolio management works411

22 The cost of equity419

22.1 Return required by investors: the CAPM420

22.2 Properties of the CAPM424

22.3 The limits of the CAPM model425

22.4 Multifactor models429

22.5 The cost of equity based on historical returns432

22.6 The cost of equity based on current market prices434

22.A A formal derivation of the CAPM440

23 From the cost of equity to the cost of capital443

23.1 The cost of capital and the?of assets443

23.2 Alternative methods for estimating the cost of capital444

23.3 Some practical applications450

23.4 Can corporate managers influence the cost of capital?453

23.5 Cost of capital: a look at the evidence455

xi

Contents

24 The term structure of interest rates461

24.1 Fixed income securities and risk461

24.2 The different interest rate curves463

24.3 Relationship between interest rates and maturities466

24.4 The stochastic approach to modelling the rate structure469

24.5 A flashback469

Section III Corporate financial policies473

Part One Financial securities475

25 Enterprise value and financial securities477

25.1 A completely different way of looking at things477

25.2 Debt and equity478

25.3 Overview of how to compute enterprise value480

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