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 financiers from students
to CFOs. The French-language versions of the Vernimmen have 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 financial accounts on the other. The authors’ approach, which consists of guiding the reader
from financial accounting to most complex deals that have strategic implications for firms, 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 Office, The Boston Consulting Group
I’m glad to hear that Vernimmen’s unique book on finance 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 finance to high-level experts. Learning with Vernimmen is a real pleasure.
Antoine Giscard d’Estaing, CFO of Danone
Vernimmen’s Corporate 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, financier or
industrialist.
Howard Jones, Fellow in Finance at the Saı̈d Business School, Oxford University, UK
This book was the first finance book I read as a student in my twenties. I read it again in my thirties to review some of the
key finance 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 financial concepts. I have never been disappointed and have
always been able to find 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 fifties, as Vernimmen is not just another book on finance: this is finance 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 finance 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 find food for thought, as its methodological
bases are strong enough to satisfy the most demanding CFO.
Jean-Michel Moutin, CFO, Louis Vuitton Asia Pacific-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. The Vernimmen, 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 financial statements from a wide range of companies, the Vernimmen is a must.
Michael Rockinger, Professor of Finance, Director of the Institute of Banking and Finance,
HEC & FAME, University of Lausanne, Switzerland
This book efficiently bridges financial 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 finance, 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):
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Adapted and updated from the original French, first published by Éditions Dalloz, Paris, 1994
(sixth edition 2005).
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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)
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About the authors
Pascal Quiry is an adjunct finance 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 Dallocchio is 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 finance.
Yann Le Fur is a corporate finance teacher at HEC Paris business school and an
investment banker with Mediobanca in Paris (after several years with Schroders
and Citigroup).
Antonio Salvi is 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 finance and corporate governance.
Pierre Vernimmen, who died in 1996, was both an M&A dealmaker (he advised
Louis Vuitton on its merger with Moët Henessy to create LVMH, the world luxury
goods leader) and a finance teacher at HEC Paris. His book, Finance d’Entreprise,
was and still is the top-selling financial textbook in French-speaking countries and
is the forebear of Corporate 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 financial 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
9 Margin analysis: Structure
155
10 Margin analysis: Risks
178
11 Working capital and capital
expenditures
193
12 Financing
217
13 Return on capital employed and
return on equity
232
14 Conclusion of financial analysis
252
Section II
Investment analysis
259
Part One
Investment decision rules
261
15 The financial markets
263
16 The time value of money and Net
Present Value (NPV)
290
57
17 The Internal Rate of Return (IRR)
309
6 Getting to grips with consolidated
accounts
73
18 Incremental cash flows and other
investment criteria
327
7 How to cope with the most complex
points in financial accounts
94
19 Measuring value creation
345
20 Risk and investment analysis
367
Part Two
The risk of securities and the
cost of capital
385
21 Risk and return
387
Foreword by Richard Roll
xvi
Preface
xviii
List of frequently used symbols
xxii
1 What is corporate finance?
Section I
Financial analysis
1
15
Part One
Fundamental concepts in
financial analysis
17
2 Cash flows
19
3 Earnings
29
4 Capital employed and invested
capital
44
5 Walking through from earnings to
cash flow
Part Two
Financial analysis and
forecasting
8 How to perform a financial
analysis
121
123
Summary
22 The cost of equity
419
23 From the cost of equity to the
cost of capital
443
24 The term structure of interest
rates
461
Section III
Corporate financial
policies
Part One
Financial securities
473
475
25 Enterprise value and financial
securities
477
26 Debt securities
485
27 Managing net debt
512
28 Shares
538
29 Options
556
30 Hybrid securities
577
31 Selling securities
601
Part Two
Capital structure policies
635
32 Value and corporate finance
637
Part Three
Equity capital and dividend
policies
vii
753
37 Internal financing: Reinvesting cash
755
flow
38 Returning cash to shareholders:
Dividend policies
768
39 Capital increases
792
Section IV
Financial management
809
Part One
Valuation and financial
engineering
811
40 Valuation
813
41 Choice of corporate structure
844
42 Taking control of a company
873
43 Mergers and demergers
894
44 Leveraged buyouts (LBOs)
912
45 Bankruptcy and restructuring
923
Part Two
Managing net debt and
financial risks
937
46 Managing cash flows
939
47 Asset-based financing
956
48 Managing financial risks
972
992
33 Capital structure and the theory
of perfect capital markets
657
34 The tradeoff model
668
Glossary
35 Debt, equity and options theory
698
Index
1002
Vernimmen.com
1031
Cribsheet
1032
36 Working out details: The design
of the capital structure
716
Contents
Foreword by Richard Roll
Preface
List of frequently used symbols
1
What is corporate finance?
1.1
1.2
1.3
1.4
1.5
The financial manager is first and foremost a salesman . . .
. . . of financial securities . . .
. . . valued continuously in the financial markets
Most importantly, he is a negotiator . . .
. . . and he remembers to do an occasional reality check!
Section I
Part One
Financial analysis
Fundamental concepts in financial analysis
2
Cash flows
2.1
2.2
Operating and investment cycles
Financial resources
3
Earnings
3.1
3.2
Additions to wealth and deductions to wealth
Different income statement formats
4
Capital employed and invested capital
4.1
4.2
4.3
4.4
The balance sheet: definitions and concepts
The capital-employed analysis of the balance sheet
A solvency-and-liquidity analysis of the balance sheet
A detailed example of a capital-employed balance sheet
5
Walking through from earnings to cash flow
5.1
5.2
Analysis of earnings from a cash flow perspective
Cash flow statement
6
Getting to grips with consolidated accounts
6.1
6.2
6.3
Consolidation methods
Consolidation-related issues
Technical aspects of consolidation
xvi
xviii
xxii
1
1
4
7
10
11
15
17
19
20
22
29
29
34
44
45
47
51
53
57
57
61
73
73
80
85
Contents
7
How to cope with the most complex points in financial accounts
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
7.10
7.11
7.12
7.13
7.14
7.15
7.16
7.17
7.18
7.19
Accruals
Construction contracts
Convertible bonds and loans
Currency translation adjustments
Deferred tax assets and liabilities
Dilution profit and losses
Exchangeable bonds
Goodwill
Intangible fixed assets
Inventories
Leases
Mandatory convertible bonds
Off-balance-sheet commitments
Preference shares
Perpetual subordinated loans and notes
Provisions
Stock options
Tangible fixed assets
Treasury shares
Part Two
Financial analysis and forecasting
8
How to perform a financial analysis
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
What is financial analysis?
Economic analysis of companies
An assessment of a company’s accounting policy
Standard financial analysis plan
The various techniques of financial analysis
Ratings
Scoring techniques
Expert systems
9
Margin analysis: Structure
9.1
9.2
9.3
9.4
9.5
How operating profit is formed
How operating profit is allocated
Financial assessment
Pro forma income statements (individual and consolidated accounts)
Case study: Ericsson
10
Margin analysis: Risks
10.1
10.2
10.3
10.4
How operating leverage works
A more refined analysis provides greater insight
From analysis to forecasting: the concept of normative margin
Case study: Ericsson
11
Working capital and capital expenditures
11.1 The nature of working capital
11.2 Working capital turnover ratios
94
95
95
96
97
97
99
100
100
101
104
106
108
108
110
111
111
115
116
117
121
123
123
125
137
138
139
142
143
144
155
156
166
167
172
172
178
178
182
187
188
193
193
197
ix
x
Contents
11.3 Reading between the lines of working capital
11.4 Analysing capital expenditures
11.5 Case study: Ericsson
201
207
210
12
217
218
220
227
Financing
12.1 A dynamic analysis of the company’s financing
12.2 A static analysis of the company’s financing
12.3 Case study: Ericsson
13
Return on capital employed and return on equity
13.1
13.2
13.3
13.4
Analysis of corporate profitability
Leverage effect
Uses and limitations of the leverage effect
Case study: Ericsson
14
Conclusion of financial analysis
14.1
14.2
14.3
14.4
Solvency
Value creation
Financial analysis without the relevant accounting documents
Case study: Ericsson
Section II
Part One
232
232
234
243
246
252
252
254
255
256
Investment analysis
259
Investment decision rules
261
15
The financial markets
15.1
15.2
15.3
15.4
15.5
15.6
15.7
The rise of capital markets
The functions of a financial system
The relationship between banks and companies
From value to price (1): financial communication
From value to price (2): efficient markets
Limitations in the theory of efficient markets
Investors’ behaviour
16
The time value of money and Net Present Value (NPV)
16.1
16.2
16.3
16.4
16.5
16.6
16.7
Capitalisation
Discounting
Present value and net present value of a financial security
The NPV decision rule
What does net present value depend on?
Some examples of simplification of present value calculations
Special NPV topics
17
The Internal Rate of Return (IRR)
17.1
17.2
17.3
17.4
How is internal rate of return determined?
Internal rate of return as an investment criterion
The limits of the internal rate of return
Some more financial mathematics: interest rate and yield to maturity
263
263
268
270
271
272
277
282
290
290
294
296
297
298
299
302
309
309
310
310
317
Contents
18
Incremental cash flows and other investment criteria
18.1
18.2
18.3
18.4
The predominance of NPV and the importance of IRR
The main lines of reasoning
Which cash flows are important?
Other investment criteria
19
Measuring value creation
19.1
19.2
19.3
19.4
Accounting criteria
Economic criteria
Market criteria
Putting things into perspective
20
Risk and investment analysis
327
327
329
333
334
345
348
353
357
359
20.1 A closer look at risk
20.2 The contribution of real options
367
368
373
Part Two
385
21
The risk of securities and the cost of capital
Risk and return
21.1
21.2
21.3
21.4
21.5
21.6
Sources of risk
Risk and fluctuation in the value of a security
Tools for measuring return and risk
How diversification reduces risk
Portfolio risk
Measuring how individual securities affect portfolio risk:
the beta coefficient
21.7 Choosing among several risky assets and the efficient frontier
21.8 Choosing between several risky assets and a risk-free asset:
the capital market line
21.9 How portfolio management works
22
The cost of equity
22.1
22.2
22.3
22.4
22.5
22.6
22.A
Return required by investors: the CAPM
Properties of the CAPM
The limits of the CAPM model
Multifactor models
The cost of equity based on historical returns
The cost of equity based on current market prices
A formal derivation of the CAPM
23
From the cost of equity to the cost of capital
23.1
23.2
23.3
23.4
23.5
The cost of capital and the of assets
Alternative methods for estimating the cost of capital
Some practical applications
Can corporate managers influence the cost of capital?
Cost of capital: a look at the evidence
387
387
389
392
394
396
401
405
407
411
419
420
424
425
429
432
434
440
443
443
444
450
453
455
xi
xii
Contents
24
The term structure of interest rates
24.1
24.2
24.3
24.4
24.5
Fixed income securities and risk
The different interest rate curves
Relationship between interest rates and maturities
The stochastic approach to modelling the rate structure
A flashback
Section III
Part One
Corporate financial policies
Financial securities
25
Enterprise value and financial securities
25.1
25.2
25.3
25.4
A completely different way of looking at things
Debt and equity
Overview of how to compute enterprise value
Valuation by discounting free cash flows
26
Debt securities
26.1
26.2
26.3
26.4
26.5
26.6
Basic concepts
The yield to maturity
Floating rate bonds
Other debt securities
The volatility of debt securities
Default risk and the role of rating
27
Managing net debt
27.1
27.2
27.3
27.4
27.5
27.6
General features of corporate financing
Marketable debt securities
Bank debt products
Leasing
Project financing
Investment of cash
28
Shares
28.1
28.2
28.3
28.4
Basic concepts
Price/Earnings ratio
Key market data
Adjusting per-share data for technical factors
29
Options
29.1
29.2
29.3
29.4
29.5
29.6
Definition and theoretical foundation of options
Mechanisms used in pricing options
Analysing options
Parameters to value options
Methods for pricing options
Tools for managing an options position
461
461
463
466
469
469
473
475
477
477
478
480
480
485
487
489
492
495
499
503
512
512
517
520
527
530
533
538
538
545
548
550
556
557
559
561
564
566
570
Contents
30
Hybrid securities
30.1
30.2
30.3
30.4
Warrants
Convertible bonds
Preference shares
Other hybrid securities
31
Selling securities
31.1
31.2
31.3
31.4
31.5
31.6
31.7
General principles in the sale of securities
Initial public offerings (IPOs)
Capital increases
Block trades of shares
Bonds
Convertible and exchangeable bonds
Syndicated loans
Part Two
Capital structure policies
32
Value and corporate finance
32.1
32.2
32.3
32.4
32.5
The purpose of finance is to create value
Value creation and markets in equilibrium
Value and organisation theories
How can we create value?
Value and taxation
33
Capital structure and the theory of perfect capital markets
33.1 The evidence from the real world
33.2 The capital structure policy in perfect financial markets
34
The tradeoff model
34.1
34.2
34.3
34A
The
The
The
The
benefits of debt
costs of debt
tradeoff model
capital structure choice: the Endesa case
35
Debt, equity and options theory
35.1
35.2
35.3
35.4
Analysing the firm in light of options theory
Contribution of the options theory to the valuation of equity
Using options theory to analyse a company’s financial decisions
Resolving conflicts between shareholders and creditors
36
Working out details: The design of the capital structure
36.1
36.2
36.3
36.4
36.5
36.6
36A
The major concepts
Competitors, lifecycle and other capital structure determinants
Other factors affecting the capital structure choice
Effects of the financing choice on accounting and financial criteria
Working out the details of the capital structure
Capital structure policies: a look at the evidence
Capital structure design: the Alitalia case
577
578
582
588
591
601
601
607
613
618
620
626
626
635
637
637
640
644
650
651
657
658
660
668
669
681
687
695
698
699
701
704
708
716
717
722
726
729
733
741
747
xiii
xiv
Contents
Part Three
37
Equity capital and dividend policies
Internal financing: Reinvesting cash flow
37.1 Reinvested cash flow and the value of equity
37.2 Internal financing and the various stakeholders
37.3 Internal financing and return criteria
38
Returning cash to shareholders: Dividend policies
38.1
38.2
38.3
38.4
Dividends and market value
Dividend distribution in practice
Share buybacks
Taxation of dividends, share buybacks and capital reduction
39
Capital increases
39.1
39.2
39.3
39.4
A definition of capital increase
Capital increases and finance theory
Old and new shareholders
Capital increases and financial criteria
Section IV
Part One
Financial management
Valuation and financial engineering
753
755
756
759
760
768
768
772
778
783
792
792
794
796
799
809
811
40
Valuation
813
40.1
40.2
40.3
40.4
40.5
40.6
40.7
Overview of the different methods
Premiums and discounts
Valuation by discounted cash flow
Multiple approach or peer group comparisons
The sum-of-the-parts method and Restated Net Asset Value (RNAV)
Example: valuation of Ericsson
Comparison of valuation methods
813
814
818
826
832
835
837
844
844
853
857
865
867
41
Choice of corporate structure
41.1
41.2
41.3
41.4
41.5
Shareholder structure
Initial Public Offerings (IPOs) and corporate governance
How to strengthen control over a company
Financial securities’ discounts
Organising a diversified group
42
Taking control of a company
42.1 The rise of mergers and acquisitions
42.2 Choosing a negotiating strategy
42.3 Taking over a listed European company
43
Mergers and demergers
43.1 All-share deals
43.2 The mechanics of all-share transactions
43.3 Demergers and splitoffs
873
873
877
882
894
894
899
904
Contents
44
Leveraged buyouts (LBOs)
44.1 LBO structures
44.2 The players
44.3 LBOs and financial theory
912
912
915
920
45.1 Causes of bankruptcy
45.2 Bankruptcy and financial theory
45.3 An illustrative example of financial restructuring
923
923
928
931
Part Two
937
45
Bankruptcy and restructuring
Managing net debt and financial risks
46
Managing cash flows
46.1
46.2
46.3
46.4
Basic tenets
Cash management
Cash management within a group
Investment of cash
47
Asset-based financing
47.1
47.2
47.3
47.4
Reasons for using asset-based financing
Main techniques
Accounting treatment
Consequences for financial analysis
48
Managing financial risks
48.1
48.2
48.3
48.4
The various sources of financial risk
Measuring financial risks
Principles of financial risk management
Organised markets–OTC markets
Glossary
Index
Vernimmen.com
Cribsheet
939
939
942
947
951
956
956
958
964
968
972
972
973
975
985
992
1002
1031
1032
xv
Foreword by Richard Roll
Thirty years ago, when I lived and worked in Europe, only a handful of financial
scholars resided on that continent and no finance texts had a European focus. How
things have changed! This book is a wonderful example of the progress that has
been made. Pierre Vernimmen became an important catalyst for change when he
published (in French) one of the first European-oriented corporate finance texts in
the 1970s. It is now available in English, updated, expanded and rendered
invaluable not only to students but also to practising financial managers.
The book itself covers all the important techniques that a financial manager
must have in his repertoire of tools. Its scope is breathtaking: from the basics of
financial analysis through accounting, capital markets, risk, arbitrage, portfolio
analysis, options, agency and signalling concepts, to the ultimate goal of corporate
finance, decision making about equity issuance, leverage, mergers, bankruptcy and
other important financial events. The exposition is clear and concise and, most
importantly, relies on commonsense reasoning throughout. This is not a book
with obscure formulae, yet is still rigorous and at the same time a model of clarity.
Two noteworthy attributes of the book are, first, its association with an
excellent website and, second, the commitment of the authors to issue a monthly
newsletter with updated research information about topical issues. In the December
2004 newsletter, for example, we find a tabulation of corporate income tax rates
compared across countries and traced over time. There are also fascinating articles
about forming a European-wide company, on how joining or leaving an index
affects an individual firm’s stock price and on whether it makes sense for European
firms to list their stock on an American exchange (in general, it doesn’t).
The website is even better. It provides lots of data to those who feel a burning
need to perform a few statistical calculations. It has an extensive glossary and a
comprehensive research bibliography about every important topic in finance.
It even has quizzes to test your financial acumen, cross-referenced against chapters
in Corporate Finance where the answers, given briefly on the Web, are explained in
detail. I enjoyed going through these quizzes even though getting a few wrong
answers was humbling.
It seems to me that the European focus of this book is entirely appropriate for
European financial managers and for students who wish to pursue careers in
finance. There are enough international differences in legal systems, accounting
methods and management practices to make a focused text invaluable. Of
course, the basic principals of finance are universal, but examples, case studies,
problem sets and quizzes are much more transparent when they involve a familiar
and realistic setting. In summary, if I were teaching corporate finance in Europe or
Foreword by Richard Roll
consulting with a financial team at a European company, I would strongly urge
everyone, from students up through the CFO, to possess this book. It contains the
answers to most questions that financial managers ask every day and, most
importantly, the answers are easy to find.
Richard Roll
Japan Alumni Chair in International Finance at the UCLA Anderson School
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