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Corporate Finance
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www.pearsoned.co.uk/watsonhead
Corporate Finance
Principles & Practice
Denzil Watson and Antony Head
The material is covered in a way which is easy for students to understand…
The quality of the questions was sound and they were well-focused…
References and recommended reading were some of the best I have encountered.
Penny Belk, Lecturer in Finance, Loughborough University Business School
The very good case studies and the examples create suitable links between the theoretical
concepts examined and real life cases.
Dr Panagiotis Andrikopoulos, Senior Lecturer in Finance, Department of Acounting and Finance,
De Montfort University
The fourth edition of Corporate Finance: Principles & Practice – now in full colour throughout – is a concise introduction to
the core concepts and key topic areas of corporate fi nance. It offers integrated coverage of the three key decision areas in
fi nance – investment, fi nancing and dividends – using a clear and logical framework for study and incorporates a wide range
of topical real-world examples, allowing students to relate theory to practice. This book provides the ideal structure for any
corporate fi nance course, particularly where there are time constraints due to modular delivery.
Corporate Finance: Principles & Practice is suitable for specialist and non-specialist corporate and business fi nance courses
at undergraduate, DMS and MBA/management at Masters level.
Key features
● Provides a student-friendly approach to the key topics in corporate fi nance.
● Introduces appropriate tools and techniques for the fi nancial manager.
● Vignettes featuring well-known companies to illustrate topics.
● Worked examples to consolidate learning points.
● Wide range of question material, both for practice and group discussion.
New features
● Full-colour format with an excellent range of features, including key points referenced throughout the text, to help student
learning and development.
● Analysis of growing areas such as value management and shareholder value.
● Questions that encourage critical thinking.
● A downloadable web supplement is available for lecturers and students at www.pearsoned.co.uk/watsonhead.
Denzil Watson BA (Economics), MA (Money, Banking and Finance) and Antony Head BSc (Chemical Engineering), MBA,
PGCFHE are both Senior Lecturers in the Faculty of Organisation and Management at Sheffi eld Hallam University.
They have extensive experience of teaching corporate fi nance, managerial fi nance and strategic fi nancial management
in a wide range of courses at undergraduate, postgraduate and professional level.
ISBN 0-273-70644-6
9 780273 706441
www.pearson-books.com
The best aspect of the book is its accessibility and conciseness –
unlike many books in the fi eld it is a readable text which gets the main points across quickly.
Kerry Sullivan, Senior Tutor Finance, School of Management, Surrey University
Overall the book’s content is very well balanced, covering all the major areas within the corporate fi nance
fi eld to a suitable depth and level for the intended audience. The writing style is also extremely engaging.
Richard Trafford, Senior Lecturer in Finance, Department of Accounting and Law, University of Portsmouth
The book is of an appropriate level for students on the MBA course…They fi nd the content of the book is not too
daunting and more importantly the book is of an appropriate length for a module of one semester.
Mike Buckle, Senior Lecturer, School of Business and Economics, University of Swansea
Corporate Finance Denzil Watson and Antony Head
fourth edition
fourth
edition
0273706446_04_COVER.indd 1 27/9/06 09:19:56
Corporate Finance
Principles & Practice
Visit the Corporate Finance: Principles & Practice,
fourth edition Companion Website at www.
pearsoned.co.uk/watsonhead to find valuable
student learning material including:
■ Multiple choice questions to help test your learning
■ Links to relevant sites on the web
CORF_A01.qxd 10/23/06 12:42 PM Page i
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Corporate Finance
Principles & Practice
fourth edition
Denzil Watson and Antony Head
Sheffield Hallam University
CORF_A01.qxd 10/23/06 12:42 PM Page iii
Pearson Education Limited
Edinburgh Gate
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Essex CM20 2JE
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and Associated Companies throughout the world
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First edition published under the Financial Times Pitman Publishing imprint in 1998.
Second edition published under the Financial Times Prentice Hall imprint in 2001
Third edition published 2004
Fourth edition published 2007
© Pearson Education Limited 2007
The rights of Hugh Denzil Watson and Antony Head to be identified as authors of this work
have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
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ISBN-13: 978-0-273-70644-1
ISBN-10: 0-273-70644-6
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
A catalogue record for this book is available from the Library of Congress
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Typeset in 10/13pt Sabon by 73
Printed and bound by Graficas Estella, Bilbao, Spain
The publisher’s policy is to use paper manufactured from sustainable forests.
Tony would like to thank Aidan and Rosemary for their love
and courage, and dedicates this book to the memory of Lesley
Head (1952–2005), dear wife and mother.
Denzil would like to thank Dora, Hugh and Doreen for their
support and care.
CORF_A01.qxd 10/23/06 12:42 PM Page iv
Preface and acknowledgements xii
Guided tour of the book xiv
1 The finance function 1
LEARNING OBJECTIVES · INTRODUCTION
1.1 Two key concepts in corporate finance 2
1.2 The role of the financial manager 5
1.3 Corporate objectives 8
1.4 How is shareholder wealth maximised? 10
1.5 Agency theory 11
Vignette 1.1 Shrinking share options 16
1.6 Corporate governance 18
Vignette 1.2 Most companies ‘flout code on corporate governance’ 20
1.7 Conclusion 21
Vignette 1.3 Higgs review sets out boardroom code 22
Vignette 1.4 Bonuses undermining pay link with performance 23
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
2 Capital markets, market efficiency and ratio analysis 29
LEARNING OBJECTIVES · INTRODUCTION
2.1 Sources of business finance 30
2.2 Capital markets 33
2.3 Capital market efficiency 34
2.4 Assessing financial performance 41
Vignette 2.1 If only investors could compare like with like 44
2.5 Conclusion 58
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
3 Short-term finance and the management
of working capital 67
LEARNING OBJECTIVES · INTRODUCTION
3.1 The objectives of working capital management 68
3.2 Working capital policies 68
Contents
v
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3.3 Working capital and the cash conversion cycle 72
Example Calculating working capital required 72
3.4 Overtrading 74
3.5 The management of stock 75
Example Using the EOQ model 77
3.6 The management of cash 79
3.7 The management of debtors 82
Example Evaluating a change in debtor policy 84
Example Cost–benefit analysis of factoring 86
3.8 Conclusion 86
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
4 Long-term finance: equity finance 93
LEARNING OBJECTIVES · INTRODUCTION
4.1 Equity finance 94
4.2 The stock exchange 96
Vignette 4.1 IPOs the chosen route as equity markets advance 98
Vignette 4.2 Laura Ashley rights issue shunned 100
Vignette 4.3 Nightfreight to go private via £35m management buy-out 102
4.3 Rights issues 103
Example Calculation of the theoretical ex rights price 104
Example Wealth effect of a rights issue 105
Vignette 4.4 Opinions split on Pearson discounted rights issue 108
4.4 Scrip issues, share splits, scrip dividends and share repurchases 108
Vignette 4.5 3i shareholders to reap £500m 110
4.5 Preference shares 111
4.6 Conclusion 112
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
5 Long-term finance: debt finance, hybrid finance
and leasing 119
LEARNING OBJECTIVES · INTRODUCTION
5.1 Loan stock and debentures 120
Vignette 5.1 Bayer’s €2bn in convertibles 122
Vignette 5.2 Ahold looks for breathing space 124
Vignette 5.3 Hellas’ €500m Pik 125
Vignette 5.4 New issues: Denmark and VNU meet strong demand 126
5.2 Bank and institutional debt 126
Example Interest and capital elements of annual loan payments 126
5.3 International debt finance 127
5.4 Convertible bonds 128
Example Convertible bond terms 129
Contents
vi
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5.5 Warrants 130
5.6 The valuation of fixed-interest bonds 131
Example Valuation of an irredeemable bond 132
Example Valuation of a redeemable bond with annual interest 132
Example Valuation of a redeemable bond with semi-annual interest 133
5.7 The valuation of convertible bonds 133
Example Valuation of a convertible bond 134
5.8 Leasing 136
Vignette 5.5 Leasing looks like a worthwhile option 139
Example Evaluation of leasing versus borrowing to buy 141
5.9 Conclusion 143
Vignette 5.6 Independent’s rights issue delivers a reality check 144
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
6 An overview of investment appraisal methods 152
LEARNING OBJECTIVES · INTRODUCTION
6.1 The payback method 153
6.2 The return on capital employed method 155
Example Calculation of the return on capital employed 156
6.3 The net present value method 158
Example Calculation of the net present value 159
6.4 The internal rate of return method 162
Example Calculation of internal rates of return 163
6.5 A comparison of the NPV and IRR methods 166
6.6 The profitability index and capital rationing 170
6.7 The discounted payback method 173
6.8 Conclusion 174
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
7 Investment appraisal: applications and risk 182
LEARNING OBJECTIVES · INTRODUCTION
7.1 Relevant project cash flows 183
7.2 Taxation and capital investment decisions 184
Example NPV calculation involving taxation 187
7.3 Inflation and capital investment decisions 188
Example NPV calculation involving inflation 190
7.4 Investment appraisal and risk 192
Example Application of sensitivity analysis 193
7.5 Empirical investigations of investment appraisal 199
7.6 Conclusion 201
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
Contents
vii
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8 Portfolio theory and the capital asset pricing model 209
LEARNING OBJECTIVES · INTRODUCTION
8.1 The measurement of risk 210
8.2 The concept of diversification 213
8.3 Investor attitudes to risk 217
8.4 Markowitz’s portfolio theory 219
8.5 Introduction to the capital asset pricing model 222
8.6 Using the CAPM to value shares 223
Vignette 8.1 Sizing up the historical equity risk premium 230
8.7 Empirical tests of the CAPM 231
8.8 Conclusion 234
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
9 The cost of capital and capital structure 241
LEARNING OBJECTIVES · INTRODUCTION
9.1 Calculating the cost of individual sources of finance 242
9.2 Calculating the weighted average cost of capital 246
Example Calculation of the weighted average cost of capital 247
9.3 Average and marginal cost of capital 249
9.4 The CAPM and investment appraisal 250
Example The CAPM in the investment appraisal process 253
9.5 Practical problems with calculating WACC 255
9.6 WACC in the real world 257
9.7 Gearing: its measurement and significance 258
Vignette 9.1 Leeds defends Woodgate sale 260
9.8 The concept of an optimal capital structure 261
9.9 The traditional approach to capital structure 262
9.10 Miller and Modigliani (I): the net income approach 264
Example Arbitrage process using two companies 265
9.11 Miller and Modigliani (II): corporate tax 267
9.12 Market imperfections 267
9.13 Miller and personal taxation 270
9.14 Pecking order theory 271
9.15 Does an optimal capital structure exist? A conclusion 272
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
10 Dividend policy 282
LEARNING OBJECTIVES · INTRODUCTION
10.1 Dividends: operational and practical issues 283
10.2 The effect of dividends on shareholder wealth 286
10.3 Dividend irrelevance 286
10.4 Dividend relevance 288
Contents
viii
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Vignette 10.1 Prudential down 18% on dividend fears 289
Vignette 10.2 M&S buoyed by relief 290
Example Calculation of share price using dividend growth model 291
10.5 Dividend relevance or irrelevance? 293
10.6 Dividend policies 293
Vignette 10.3 FT MONEY: Dubious dividend decisions
that drive me to despair 294
10.7 Alternatives to cash dividends 297
Vignette 10.4 Cadbury defends the bid price 298
Vignette 10.5 Share buybacks rise 92% in US 299
10.8 Empirical evidence on dividend policy 301
10.9 Conclusion 302
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
11 Mergers and takeovers 311
LEARNING OBJECTIVES · INTRODUCTION
11.1 The terminology of mergers and takeovers 312
11.2 Justifications for acquisitions 313
Example Boot-strapping 316
11.3 Trends in takeover activity 318
Vignette 11.1 Water faces up to rising debt levels 320
11.4 Target company valuation 321
Example Takeover (Simpson and Stant) 321
11.5 The financing of acquisitions 328
Vignette 11.2 Morrison bid value drops to £2bn 330
11.6 Strategic and tactical issues 332
Vignette 11.3 The Takeover Panel cracks down on Indigo 335
Vignette 11.4 More EU member states opt for ‘poison pill’ 338
Vignette 11.5 No slanging match as BPB attempts to prove that
its case is mathematically correct 339
11.7 Divestment 340
Vignette 11.6 Just a mention of spin-off can unlock value
for shareholders 342
Vignette 11.7 RSA’s health insurer in £147m MBO 343
11.8 Empirical research on acquisitions 345
11.9 Conclusion 348
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
12 Risk management 359
LEARNING OBJECTIVES · INTRODUCTION
12.1 Interest and exchange rate risk 360
Vignette 12.1 Balance sheets left reeling by the Real 361
Vignette 12.2 Daimler increases hedging against dollar 363
Contents
ix
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12.2 Internal risk management 366
12.3 External risk management 368
Example Forward rate agreement 369
Example Money market hedge 370
12.4 Futures contracts 370
Example Using interest rate futures 371
Example Using US currency futures 372
12.5 Options 373
Example Using interest rate options 376
Example Using exchange rate options 376
12.6 Swaps 379
Vignette 12.3 Interest rate swaps: changing hopes boost volume 380
Example Plain vanilla interest rate swap 381
Example Fixed to floating currency swap 383
12.7 Issues in risk management 385
Vignette 12.4 Companies ‘too short sighted when hedging’ 386
12.8 Conclusion 390
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
13 International investment decisions 397
LEARNING OBJECTIVES · INTRODUCTION
13.1 The reasons for foreign investment 398
Vignette 13.1 National news: foreign direct investment
almost trebles 399
Vignette 13.2 Europe is winning the war for economic freedoms 401
Vignette 13.3 Foreign investment: competitors turn up the heat 402
13.2 Different forms of international trade 403
13.3 The evaluation of foreign investment decisions 406
Vignette 13.4 Positive experience in difficult markets 406
Example Foreign direct investment evaluation 410
13.4 The cost of capital for foreign direct investment 412
13.5 Political risk 415
13.6 Conclusion 417
KEY POINTS · SELF-TEST QUESTIONS · QUESTIONS FOR REVIEW ·
QUESTIONS FOR DISCUSSION · REFERENCES · RECOMMENDED READING
Appendix: Answers to end-of-chapter questions 425
Glossary 479
Present value tables 487
Index 489
Contents
x
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Supporting resources
Visit www.pearsoned.co.uk/watsonhead to find valuable online resources
Companion Website for students
■ Multiple choice questions to help test your learning
■ Links to relevant sites on the web
For instructors
■ Complete, downloadable Instructor’s Manual
■ Additional assessment questions (with answers) for each chapter to test student
understanding and progress
■ Answers to the questions for discussion in the book
■ PowerPoint slides that can be downloaded and used for presentations
Also: The Companion Website provides the following features:
■ Search tool to help locate specific items of content
■ E-mail results and profile tools to send results of quizzes to instructors
■ Online help and support to assist with website usage and troubleshooting
For more information please contact your local Pearson Education sales
representative or visit www.pearsoned.co.uk/watsonhead
CORF_A01.qxd 10/23/06 12:42 PM Page xi
xii
Introduction
Corporate finance is concerned with the financing and investment decisions made by
the management of companies in pursuit of corporate goals. As a subject, corporate
finance has a theoretical base which has evolved over many years and which continues
to evolve as we write. It has a practical side too, concerned with the study of how companies actually make financing and investment decisions, and it is often the case that
theory and practice disagree.
The fundamental problem that faces financial managers is how to secure the greatest
possible return in exchange for accepting the smallest amount of risk. This necessarily
requires that financial managers have available to them (and are able to use) a range of
appropriate tools and techniques. These will help them to value the decision options
open to them and to assess the risk of those options. The value of an option depends
upon the extent to which it contributes towards the achievement of corporate goals. In
corporate finance, the fundamental goal is usually taken to be to increase the wealth of
shareholders.
The aim of this book
The aim of this text is to provide an introduction to the core concepts and key topic
areas of corporate finance in an approachable, ‘user-friendly’ style. Many texts on
corporate finance adopt a theory-based or mathematical approach which are not
appropriate for those coming to the subject for the first time. This book covers the core
concepts and key topic areas without burdening the reader with what we regard as
unnecessary detail or too heavy a dose of theory.
Flexible course design
Many undergraduate courses are now delivered on a modular or unit basis over one
teaching semester of 12 weeks’ duration. In order to meet the constraints imposed by
such courses, this book has been designed to support self-study and directed learning.
There is a choice of integrated topics for the end of the course.
Each chapter offers:
■ a comprehensive list of key points to check understanding and aid revision;
■ self-test questions, with answers at the end of the book, to check comprehension of
concepts and computational techniques;
Preface
CORF_A01.qxd 10/23/06 12:42 PM Page xii
Preface
xiii
■ questions for review, with answers at the end of the book, to aid in deepening
understanding of particular topic areas;
■ questions for discussion, answers for which are available in the Lecturer’s Guide;
■ comprehensive references to guide the reader to key texts and articles;
■ suggestions for further reading to guide readers who wish to study further.
A comprehensive glossary is included at the end of the text to assist the reader in grasping any unfamiliar terms that may be encountered in the study of corporate finance.
New for the fourth edition
The fourth edition has been extensively revised and updated in order to keep its content fresh and relevant. Apart from considerable revision of the text, many vignettes
have been updated to reflect current events and developments in the financial world.
The fourth edition has also benefited from a major restructuring in the chapter
sequencing. This has brought a more logical flow to the book, not only in terms of the
order in which the subject material is covered but also from the perspective of the
complexity of the material. The number of questions for review and discussion at
the end of each chapter has been increased. The Companion Website for the book has
been reviewed and updated, with many more multiple choice questions provided to aid
student learning. The PowerPoint slides offered to lecturers have also been revised to
reflect the content of the fourth edition. We trust that our readers will find these
changes useful and constructive.
Target readership
This book has been written primarily for students taking a course in corporate finance
in their second or final year of undergraduate study on business studies, accounting
and finance-related degree programmes. It may also be suitable for students on professional and postgraduate business and finance courses where corporate finance or
financial management are taught at introductory level.
Author acknowledgements
We are grateful to our reviewers for helpful comments and suggestions. We are also
grateful to the undergraduate and postgraduate students of Sheffield Hallam University
who have taken our courses and, thereby, helped in developing our approach to the
teaching and learning of the subject. We are particularly grateful to our editor Justinia
Seaman of Pearson Education for her patience and encouragement and assistant editor
Stephanie Poulter for providing invaluable review information and feedback on the
book drafts. We also extend our gratitude to our many colleagues at Sheffield Hallam
University, with special thanks going to Geoff Russell for those vital statistics we
couldn’t find ourselves.
CORF_A01.qxd 10/23/06 12:42 PM Page xiii
Guided tour of the book
The finance function
Chapter 1
Learning objectives
After studying this chapter, you should have achieved the following learning
objectives:
■ an understanding of the time value of money and the relationship
between risk and return;
■ an appreciation of the three decision areas of the financial manager;
■ an understanding of the reasons why shareholder wealth maximisation is
the primary financial objective of a company, rather than other objectives
a company may consider;
■ an understanding of why the substitute objective of maximising a
company’s share price is preferred to the objective of shareholder
wealth maximisation;
■ an understanding of how agency theory can be used to analyse the
relationship between shareholders and managers, and of ways in which
agency problems may be overcome;
■ an appreciation of the developing role of institutional investors in
overcoming agency problems;
■ an appreciation of how developments in corporate governance have
helped to address the agency problem.
1
Chapter 1 The finance function
16
Shrinking share options
Vignette 1.1
FT
Source: Financial Times, 13 August 2005. Reprinted with permission.
Measures intended to deal with a
problem often have unintended
consequences while failing to achieve
their purpose. So it is gratifying that
one recent reform is having exactly
the desired impact. Share option
schemes are becoming less popular
now their cost has to be deducted
from earnings.
The change was introduced after
the collapse of the 1990s’ stock market bubble when it became clear that
some executives had used share
option schemes to loot their companies. One estimate is that more than
$1,000bn (£550bn) was transferred to
executives from shareholders in
Standard & Poor’s 500 companies.
Longer-term damage was wrought in
many companies whose management
was manipulated to maximise the
gains from share options.
Previously, share option details had
to be disclosed in footnotes to financial statements. But few investors
appeared to have understood the
value of such options until it was
exposed after the bubble burst. New
accounting standards on both sides of
the Atlantic have since been drafted
that require the value of options to be
deducted as an expense in the profit
and loss account.
The new standards are being implemented now, with some companies
expensing options even before they
were required to. A survey by PwC, the
accountancy firm, suggests there has
already been an impact on executive
remuneration. The proportion of incentive awards for the chief executives of
FTSE-100 companies has fallen from
36 per cent to 21 per cent this year.
It should probably fall further. There
is an argument that share options are
a good way for small, growing companies to attract good staff when they
cannot pay salaries to match those
offered by larger employers. But it is
not clear why big, established companies that can afford to pay top
dollar should grant share options –
apart from the fact that they were not
recorded as an expense under the
old standards.
Now that share options will have to
be expensed, the trend away from
such schemes is likely to continue.
Some companies continue to argue
that since no money changes hands,
expensing options is a theoretical
exercise. Others point to difficulties in
valuing options. There are also concerns about the volatility that will result
as option values are recalculated periodically.
None of these arguments stands
scrutiny. There is clearly a value to
share options – otherwise the recipients
would not want them. The company
has made a financial commitment it will
have to meet in the future if the share
price rises above the strike price.
Calculating the value of options is
not an exact science. But that is true
of many items in accounts, such as
depreciation or amortisation, bad debt
charges and contingent liabilities. The
best estimates of their value is still
worth including in accounts – and certainly better than omitting them.
Finally, volatility is inherent in markets. Indeed, one reason for the
accounting shenanigans uncovered
when the stock market bubble burst
was management’s desire to report
steadily rising earnings per share. In
the real world, business performance
goes up and down – a reality that
investors must learn to accept.
The PwC survey also showed that
more companies are using share
awards as incentives, up from 57 per
cent to 68 per cent for FTSE-100 chief
executives. They are finding it cheaper
since employees see more value in free
shares than in options potentially worth
more. Everyone is thus a winner –
shareholders and employees alike.
1.5.5 The influence of institutional investors
In Section 1.5.3 we implied that an increase in the concentration of share ownership
might lead to a reduction in the problems associated with agency. In the UK in recent
years, especially over the late 1970s and to a lesser extent subsequently, there has
been an increase in shareholdings by large institutional investors. This trend is clearly
apparent in Exhibit 1.6, where it can be seen that institutional shareholders currently
account for the ownership of approximately 51 per cent of all ordinary share capital.
One marked change in recent years has been the steep decline in the number of shares
The management of stock
77
Q is now the economic order quantity, i.e. the order quantity which minimises the
sum of holding costs and ordering costs. This formula is called the economic order
quantity (EOQ) model.
More sophisticated stock management models have been developed which relax
some of the classical model’s assumptions, whereas some modern approaches, such
as just-in-time methods (see Section 3.5.3) and material resource planning (MRP),
question the need to hold any stock at all.
Using the EOQ model
Oleum plc sells a soap called Fragro, which it buys in boxes of 1000 bars with ordering costs of £5 per order. Retail sales are 200 000 bars per year and holding costs are
£2.22 per year per 1000 bars. What is the economic order quantity and average
stock level for Fragro?
Suggested answer
F £5 per order
S 200 000 bars per year
H £2.22 per 1000 bars
so:
Q (2 200 000 5(2.221000))12
30 015 bars, or approximately 30 boxes
The average stock level Q2 30 0002 15 000 bars.
Example
3.5.2 Buffer stocks and lead times
There will usually be a delay between ordering and delivery, and this delay is known
as lead time. If demand and lead time are assumed to be constant, new stock should
be ordered when the stock in hand falls to a level equal to the demand during
the lead time. For example, if demand is 10 400 units per year and the lead time for
delivery of an order is two weeks, the amount used during the lead time is:
10 400 (252) 400 units
New stock must be ordered when the level of stock in hand falls to 400 units. If
demand or lead times are uncertain or variable, a company may choose to hold buffer stock to reduce or eliminate the possibility of stockouts (running out of stock). It
could optimise the level of buffer stock by balancing holding costs against the potential costs of stockouts. However, the EOQ model can still be used to determine an
optimum order size.
Chapter 1 The finance function
24
Key points
1Two key concepts in corporate finance are the relationship between risk and
return, and the time value of money.
2Compounding calculates future values from an initial investment. Discounting
calculates present values from future values. Discounting can also calculate the
present values of annuities and perpetuities.
3While accountancy plays an important role within corporate finance, the fundamental problem addressed by corporate finance is how best to allocate the scarce
resource of money.
4Financial managers are responsible for making decisions about raising funds (the
financing decision), allocating funds (the investment decision) and how much to
distribute to shareholders (the dividend decision).
5While objectives such as profit maximisation, social responsibility and survival
represent important supporting objectives, the overriding objective of a company must be that of shareholder wealth maximisation.
6Due to its visibility, maximisation of a company’s ordinary share price is used as
a substitute objective to that of maximisation of shareholder wealth.
7A financial manager can maximise a company’s market value by making investment, financing and dividend decisions consistent with shareholder wealth
maximisation.
8Managers do not always act in the best interests of their shareholders, giving rise
to what is called the agency problem.
9Agency is most likely to be a problem when there is a divergence of ownership
and control, when the goals of managers differ from those of shareholders, and
when asymmetry of information exists.
1An example of how the agency problem can manifest within a company is
where managers diversify away unsystematic risk to reduce the company’s risk,
thereby increasing their job security.
1Monitoring and performance-related benefits are two potential ways to optimise
managerial behaviour and encourage goal congruence.
2Owing to difficulties associated with monitoring, incentives such as performancerelated pay and executive share options represent a more practical way of
encouraging goal congruence.
1Institutional shareholders own approximately 51 per cent of all UK ordinary
shares. Recently, they have brought pressure to bear on companies that do not
comply with corporate governance standards.
1Corporate governance problems have received a lot of attention owing to a
number of high-profile corporate collapses and the publicising of self-serving
executive remuneration packages.
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Learning objectives list the topics covered and what
the reader should have learnt by the end of the chapter
Vignettes feature extracts from topical news articles
Examples appear throughout the text, giving worked
examples and computational techniques
Key points summarise and recap the main points of the
chapter, providing an important revision tool
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