Analytical Corporate Finance

Springer Texts in Business and Economics

Angelo Corelli

Analytical

Corporate

Finance

Second Edition

Springer Texts in Business and Economics

More information about this series at http://www.springer.com/series/10099

Angelo Corelli

Analytical Corporate

Finance

Second Edition

Angelo Corelli

Center of Excellence for Research in

Finance and Accounting (CERFA)

American University in Dubai

Dubai, United Arab Emirates

ISSN 2192-4333 ISSN 2192-4341 (electronic)

Springer Texts in Business and Economics

ISBN 978-3-319-95761-6 ISBN 978-3-319-95762-3 (eBook)

https://doi.org/10.1007/978-3-319-95762-3

Library of Congress Control Number: 2018950554

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A Ettore, Lollo,

la Famiglia

e gli Amici

Preface to the First Edition

A Modern Approach

The book offers an innovative view of the most important areas of study for a

newcomer in finance. The book aims to be a guide through the most common and

interesting topics of corporate finance, supported by a rich mathematical foundation

(from which the term “analytical” in the book title derives).

The focus of the book is on the life of the corporation, from the start to the

implementation of the most complex projects, and the many different ways financing

can be achieved. The new approach proposed by this book involves a strong

analytical insight into each topic to give students the tools to really understand the

effects of managerial decisions on the life of the corporation.

The vision of the book is to offer a guide to corporate finance, capable of helping

students and practitioners gain an introduction to the area, as well as giving interme￾diate users useful insights into and a deeper understanding of the analytics behind

each part.

The literature of books in corporate finance spans over a wide range of topics and

theories. The market is already full of (even good) textbooks facing the issue of the

corporation from many points of view.

However, the overall offer of corporate finance textbook lacks a rigorous mathe￾matical approach. All these books share the same business-related approach to the

topic, focusing more on the corporate aspects rather than the financial substance.

The aim of Analytical Corporate Finance is to turn the attention to the financial

aspects of the daily life of the corporation, with a robust mathematical setting, and

the explanation and derivation of the mostly popular models of the firm.

The potential of filling such a niche is evident if one thinks that a course in

corporate finance nowadays makes only sense if held at the very beginning of an

undergraduate course program in basic finance.

There is a demand for high-quality education at master’s level, including a more

advanced level of corporate finance courses, which is not fulfilled nowadays and

definitely requires a good textbook as a guide for such advanced education in the

field.

vii

Corporate finance is the first area of knowledge in an ideal sequence of studies in

finance. It contains, in fact, reference to many topics in finance, which are subject to

deeper understanding in subsequent modules: risk management, derivatives pricing,

asset pricing, etc.

It is therefore very important to address each single topic in the most comprehen￾sive way, giving a complete description of the main aspects of the topic and leaving

the need for further knowledge to the curiosity of the student.

As an area, corporate finance can be thought of as an introductory aggregation of

all the main topics that constitute the object of a deeper knowledge when studying

other areas of finance.

It does not mean knowledge can be superficial or merely introductory. The

purpose of a good textbook in corporate finance is therefore to include all necessary

knowledge without missing any crucial information, but also avoiding useless

widening of the explanation beyond what can really satisfy students’ needs.

The structure of the book corresponds to the above rationale, giving a complete

view of the various topics that make up the corporate finance area, and offering a

good quantitative basis, which helps students understand the topics.

An Innovative Pedagogy

The book stands on a double pillar of theory and analytics, which merge in a way that

makes it easy for students to understand the exact meaning of the concepts and their

representation and applicability in real-world contexts. Examples are given through￾out the chapters in order to clarify the most intricate aspects; where needed, there are

appendices at the end of chapters that give more mathematical insights about specific

topics.

The duality stands at the basis of a complete learning experience, and students

may get the most out of the book if they have a prior solid background in economic

theory and an introductory level of financial mathematics. Indeed, students facing

financial topics for the first time may benefit from using the book as a medium-level

introduction to some aspects of financial theory and practice.

Due to the recent growth in knowledge demand by the private sector, practitioners

can also benefit from the chapters in the book to fill a gap between university and

industry, which stood prior to the crisis. The book provides useful information for

managers who want to increase their knowledge about risk management and under￾stand what may have been lacking in their own systems.

A Selected Audience

The book is meant for third-year undergraduate students of business finance, quanti￾tative finance, and financial mathematics, as well as first-year postgraduate (master)

students. Most universities offer the type of training in mathematics and statistics

that would be prerequisite for the successful completion of a course using Analytical

viii Preface to the First Edition

Corporate Finance. Potential users include students of universities, technical

schools, and business schools offering courses in financial risk management.

The book represents a unique and innovative approach to the field of corporate

finance. Competitors, in fact, focus on the business side of the story, centering the

discussion on corporate aspects only. There is no challenge or criticism of the

markets side, and there is no drive to understand the mathematical foundations of

theory in a critical sense. That is exactly what Analytical Corporate Finance wants

to offer instead.

A quantitative approach incorporates a more critical view, contributing to a

description of theory that does not blindly rely on numbers, indices, and ratios, but

takes into account the variety of (sometimes unpredictable) situations that character￾ize financial markets.

Certainly, it is not the typical corporate finance book, but it is a book that never

gives up on the reader. Even in the most complicated parts, which are anyway at an

intermediate level, students are guided through the processes and given the tools

they need; nothing is cryptic.

Although the market for books in corporate finance is heavily crowded, Analyti￾cal Corporate Finance aims to distinguish itself through the higher level of mathe￾matics involved, compared to the competition.

Moreover, the links to real industry examples are much more updated than other

texts can offer at the moment. Therefore, a niche in the market can be envisioned for

a book that challenges students on a more analytical than business-related level.

The book is totally comprehensive (at least for a large part of the relevant topics)

and represents a standard in introductory and mid-level study of corporate finance. In

a single book, the features that singularly belong to the most challenging competitors

now on the market are summarized and critiqued.

A Reliable Partner for Instructors

Analytic Corporate Finance is mostly tailored for in-class lectures, yielding the best

learning experience when combined with good quality lectures. The overall flexibil￾ity of the book, in 12 chapters, and the straightforward structure also make it a good

reference for online learning. However, the medium-high level of difficulty of the

book suggests the need for a closer relation with the instructor and the chance of

in-person explanations.

The structure of the book is such that a typical module of six ECTS and

approximately 30 h of front teaching would suit it. The 14 chapters fit a course

design of about 14–16 lectures of 1.5 hours of effective teaching. The structure also

fits the international standard of a course with two lectures per week spanned over a

2-month teaching term. The overall contents of the book can fill approximately 40–

60 hours of teaching.

Every chapter follows a precise structure, with the full-text body of most sections

complemented by snapshots relating to cutting-edge research and up-to-date news.

At the end of each chapter, there is an exercise section consisting of different types of

Preface to the First Edition ix

tasks. Each chapter is supplemented with a list of references and appendices which

are meant to analyze, in a deeper form, some of the mathematical issues presented in

the chapter.

Value for Students and Instructors

The rigorous mathematical approach is supported by an appropriate amount of

graphical and explanatory support, in the parts where this is needed. Overall, the

book is rich in contents of every kind.

In particular, it is convenient to summarize some statistics. The book comprises:

– 14 chapters

– 70 major learning outcomes

– 126 specific learning outcomes

– 83 numerical examples

– 203 in-text examples

– 45 figures

– 11 tables

The above contents offer the support to the body of the text and the equations that

help to clarify all the major aspects of the topics touched in the book chapters. The

work is a valid partner for instructors and students, who can find a lot of material to

learn the theory about corporate finance and practice about it with problems and

exercises.

Dubai, UAE Angelo Corelli

x Preface to the First Edition

Addendum to the Preface

This second Edition of Analytical Corporate Finance introduces meaningful and

significant additions to the previous edition, making the textbook a more reliable

source for students and instructors of courses like corporate finance, financial

management, and principles of finance.

The addition of case studies and the thorough revisiting of all the text in order to

correct mistakes and improve the narration of some topics enrich the learning

experience by shedding a clearer light on the major points of discussion.

The innovations in this edition can be summarized, by chapter, as:

Chapter 1:

• Improved Analysis of Financial Ratios

• Pro-Forma Analysis of Financial Statement

• Case Study: Pro-Forma Statements

Chapter 2:

• Case Study: Time Value of Money

Chapter 3:

• Snapshot: Risk and Return in Excel

• Case Study: Risk and Return

Chapter 4:

• Improved Coverage of Capital Budgeting Decision Rules

• Case Study: Net Present Value

Chapter 6:

• Relative Valuation Models

Chapter 7:

• Case Study: Capital Structure

Chapter 8:

• Case Study: Company Valuation

xi

Chapter 10:

• IPO Underpricing

Chapter 11:

• Conversion Cycles

• Cash and Liquidity Management

• Case Study: Conversion Cycles

xii Addendum to the Preface

Acknowledgements

First of all, I would like to thank my family for being at my side all the time. My

father Giuseppe, my mother Rina, and my brother Mauro always gave me all the

support I needed to move forward in my career.

I would like to thank Dr. Lance De Masi, President of the American University in

Dubai (AUD), UAE, for managing the university in a way that creates the perfect

environment for developing this book.

Special thanks to Mr. Elias Bou Saab, Executive Vice President of AUD, for

giving the trust and support that help me every day, since my start at AUD.

I would also like to offer special thanks to Dr. Imad Hoballah, Provost of AUD,

for making me feel respected and important in the institution where I work, thus

supporting my motivation in doing my job.

I also want to thank the leadership of the School of Business Administration

(SBA), namely, the Dean Dr. Mohammed Abu Ali, the Associate Dean Dr. Assaad

Farah, and the Assistant Dean Mr. Raj Kapoor, for their help and support in the

development of my career path in the university.

Special thanks to all my colleagues, friends, and relatives who supported me

during this journey, and (last but not least) to all my students, with whom I engaged

in fruitful discussions related to the topics covered in this book.

My sincere gratitude also goes to the team of Springer that brilliantly contributed

to this project, including the Associate Editor Rocio Torregrosa and all the

production team.

Angelo Corelli

xiii

Contents

1 Basic Concepts ......................................... 1

1.1 The Corporation . .................................. 2

1.1.1 Organizational Forms ......................... 2

1.1.2 The Corporate Objective . . . . . . . . . . . . . . . . . . . . . . . 6

1.2 Financial Statement Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 10

1.2.1 Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

1.2.2 Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

1.2.3 Cash Flow Statement . . . . . . . . . . . . . . . . . . . . . . . . . 22

1.2.4 Pro Forma Statements . . . . . . . . . . . . . . . . . . . . . . . . . 25

1.3 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

1.3.1 The Law of One Price . . . . . . . . . . . . . . . . . . . . . . . . . 30

1.3.2 Forms of Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

1.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Case Study: Pro Forma Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

2 Valuation Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

2.1 The Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

2.1.1 The Rules of Time Travel . . . . . . . . . . . . . . . . . . . . . . 42

2.1.2 Valuation of Cash Flow Streams . . . . . . . . . . . . . . . . . 47

2.1.3 Annuities and Perpetuities . . . . . . . . . . . . . . . . . . . . . . 48

2.2 Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

2.2.1 Types of Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . 52

2.2.2 Compounding Frequencies . . . . . . . . . . . . . . . . . . . . . 55

2.2.3 The Drivers of Interest Rates . . . . . . . . . . . . . . . . . . . . 56

2.3 Present Value Calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

2.3.1 Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

2.3.2 Internal Rate of Return . . . . . . . . . . . . . . . . . . . . . . . . 60

2.3.3 Growing Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . 62

2.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

xv

Case Study: Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

3 The Relationship Between Risk and Return . . . . . . . . . . . . . . . . . . . 73

3.1 Expected Return and Volatility . . . . . . . . . . . . . . . . . . . . . . . . . 74

3.1.1 The Portfolio Return . . . . . . . . . . . . . . . . . . . . . . . . . . 74

3.1.2 Volatility and Correlation . . . . . . . . . . . . . . . . . . . . . . 77

3.1.3 Maximum Likelihood Methods . . . . . . . . . . . . . . . . . . 83

3.2 Modern Portfolio Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

3.2.1 The Risk/Return Trade-Off . . . . . . . . . . . . . . . . . . . . . 87

3.2.2 Optimal Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

3.2.3 The Market Price of Risk . . . . . . . . . . . . . . . . . . . . . . 99

3.3 The Capital Asset Pricing Model . . . . . . . . . . . . . . . . . . . . . . . 102

3.3.1 Model Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . 102

3.3.2 The Security Market Line . . . . . . . . . . . . . . . . . . . . . . 106

3.3.3 Beyond CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

3.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

Appendix: Liquidity CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

Case Study: Risk and Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

4 Business Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

4.1 Capital Budgeting Decision Rules . . . . . . . . . . . . . . . . . . . . . . 122

4.1.1 The Net Present Value Rule . . . . . . . . . . . . . . . . . . . . 122

4.1.2 The Internal Rate of Return Rule . . . . . . . . . . . . . . . . . 125

4.1.3 The Payback Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

4.1.4 The Profitability Index Rule . . . . . . . . . . . . . . . . . . . . 127

4.2 Project Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

4.2.1 Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

4.2.2 Decision Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

4.2.3 Simulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

4.3 Sub-disciplines of Business Analysis . . . . . . . . . . . . . . . . . . . . 137

4.3.1 Enterprise Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

4.3.2 Business Requirements Analysis . . . . . . . . . . . . . . . . . 140

4.3.3 Analysis Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . 143

4.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

Case Study: Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

xvi Contents