Pierre Vernimmen

CORPORATE
FINANCE
THEORY AND PRACTICE

Second Edition
Pascal Quiry
Maurizio Dallocchio
Yann Le Fur
Antonio Salvi



CORPORATE FINANCE


Corporate Finance is a very useful reference book for students and for operators who will get great help in the present
complex environment to learn the principles of the financial markets and their practical application. Written with a clear and
logical approach it shows also some interesting cases that make study easier and stimulating.
Gabriele Galateri, Chairman of Telecom Italia

The book, newsletter, and website are all very interesting and useful. The book is 47 chapters (about 1 000 pages) full of
corporate finance. I have to agree with the authors: “It is a book in which theory and practice are constantly set off against
each other . . .” I really like it. Especially the emphasis not so much on techniques (“which tend to shift and change over
time”). Very well done! Moreover, the authors also put out a monthly newsletter and have a web site that could stand alone as
one of the best in the business. Check it out!
Jim Mahar, Associate Professor of Finance at St. Bonaventure University
and author of www.financeprofessor.com

As a Mexican-born, French-educated, German-based portfolio manager, I’ve worked and invested in several European
countries. The multi-country content of the “Corporate Finance: Theory and Practice” book makes it my preferred companion
as I work in a cross-border environment. Its international focus is the perfect complement to my multicultural experience.
Sergio Macias, CFA Portfolio Manager, Union Investment Privatfonds GmbH

This book was for sure 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 and I am now,
in my forties, reviewing it another time 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 . . .
Vernimmen is not another book on Finance: this is Finance as a life experiment.
Jean-Michel Moutin, CFO Christian Dior Perfumes

This corporate finance textbook makes the difference. It is an outstanding and unique blend of the theory and the practice,
European flavour and world perspective, and traditional topics and emerging themes. Above all, the book is an excellent
manual for teachers, students, and corporate managers.
Bang Dang Nguyen, Assistant Professor of Finance, the Chinese University of Hong Kong

As a business student, I appreciated this book for being both exhaustive with almost 1,000 pages and easy to digest. The
strengths of this book are its conversational writing style and emphasis on practical problem solving. For example, the
four-stage framework for financial analysis presented here is a simple yet rigorous tool to understand a company’s financial
situation. Plus the authors make theory come alive with the use of concrete examples with real companies.
This book was a fine introduction to corporate finance and continues to be a useful reference for me.
Hock Kim Teh, Associate McKinsey Frankfurt


Pierre Vernimmen

CORPORATE
FINANCE

THEORY AND PRACTICE

Second Edition
Pascal Quiry
Maurizio Dallocchio
Yann Le Fur
Antonio Salvi


c 2009 John Wiley & Sons Ltd.
Registered office
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex,
PO19 8SQ, United Kingdom
For details of our global editorial offices, for customer services and for information about how to apply for
permission to reuse the copyright material in this book please see our website at www.wiley.com.
The right of the author to be identified as the author of this work has been asserted 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 system, or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise,
except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of
the publisher.
Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may
not be available in electronic books.
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 Offices
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, 6045 Freemont Blvd. Mississauga, Ontario, L5R 4J3, Canada
Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may
not be available in electronic books.
Library of Congress Cataloging-in-Publication Data
A catalogue record for this book is available from the Library of Congress.

A catalogue record for this book is available from the British Library.
ISBN 978-0-470-72192-6
Set in 10/12pt Times by Integra Software Services Pvt. Ltd, Pondicherry, India.
Printed and bound in Great Britain by TJ International Ltd, Padstow, Cornwall


About the authors

Pascal Quiry is a professor of finance at the leading European business school HEC
Paris, and a managing director in the Corporate Finance arm of BNP Paribas specialising
in M&A.
Maurizio Dallocchio is Bocconi University Nomura Chair of Corporate Finance and Past
Dean of SDA Bocconi, School of Management. He is also a board member of international
and Italian institutions and is one of the most distinguished Italian authorities in 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 Citi.
Antonio Salvi is Caisse d’Epargne Rhone Alpes Professor of SME Finance at EM Lyon
Business School. He also teaches Corporate Finance and M&A at Bocconi University.


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; and also Matthew Cush,
Robert Killingsworth, John Olds, Gita Roux, Steven Sklar, and Patrice CarleanJones who helped us tremendously in writing this book.


Summary
A detailed table of contents can be found on page 1001

The 2007–2008 crisis, or rediscovering
financial risk
Preface
Frequently used symbols
1 WHAT IS CORPORATE FINANCE?

10 MARGIN ANALYSIS: RISKS
viii
xii
xvi

11 WORKING CAPITAL AND CAPITAL
EXPENDITURES


12 FINANCING

193
216

13 RETURN ON CAPITAL EMPLOYED AND
1

RETURN ON EQUITY

14 CONCLUSION OF FINANCIAL ANALYSIS

SECTION I
FINANCIAL ANALYSIS

178

15

230
251

SECTION II
INVESTMENT ANALYSIS

PART ONE
FUNDAMENTAL CONCEPTS IN
FINANCIAL ANALYSIS

17


PART ONE

2 CASH FLOWS

19

INVESTMENT DECISION RULES

259

3 EARNINGS

29

15 THE FINANCIAL MARKETS

261

4 CAPITAL EMPLOYED AND INVESTED
CAPITAL

16 THE TIME VALUE OF MONEY AND NET
45

5 WALKING THROUGH FROM EARNINGS TO
CASH FLOW

94


PART TWO

289
308

18 INCREMENTAL CASH FLOWS AND OTHER
INVESTMENT CRITERIA

74

7 HOW TO COPE WITH THE MOST COMPLEX
POINTS IN FINANCIAL ACCOUNTS

PRESENT VALUE

17 THE INTERNAL RATE OF RETURN
58

6 GETTING TO GRIPS WITH CONSOLIDATED
ACCOUNTS

257

326

19 MEASURING VALUE CREATION

344

20 RISK AND INVESTMENT ANALYSIS


367

PART TWO

FINANCIAL ANALYSIS AND

THE RISK OF SECURITIES AND

FORECASTING

119

THE COST OF CAPITAL

385

8 HOW TO PERFORM A FINANCIAL ANALYSIS

121

21 RISK AND RETURN

387

9 MARGIN ANALYSIS: STRUCTURE

154

22 THE COST OF EQUITY


420


SUMMARY

PART THREE

23 FROM THE COST OF EQUITY TO THE COST
OF CAPITAL

447

EQUITY CAPITAL AND
DIVIDENDS

24 THE TERM STRUCTURE OF INTEREST
RATES

vii

467

773

37 INTERNAL FINANCING: REINVESTING
CASH FLOW

PART THREE
FINANCIAL SECURITIES


479

25 BONDS

481

26 OTHER DEBT PRODUCTS

507

27 SHARES

527

28 OPTIONS

547

29 HYBRID SECURITIES

569

PART ONE

30 SELLING SECURITIES

593

CORPORATE GOVERNANCE AND


775

38 RETURNING CASH TO SHAREHOLDERS:
DIVIDEND POLICIES

788

39 CAPITAL INCREASES

815

SECTION IV
FINANCIAL MANAGEMENT

831

FINANCIAL ENGINEERING

833

40 CHOICE OF CORPORATE STRUCTURE

835

SECTION III

41 CORPORATE GOVERNANCE

862


CORPORATE FINANCIAL

42 TAKING CONTROL OF A COMPANY

876

43 MERGERS AND DEMERGERS

899

44 LEVERAGED BUYOUTS (LBOS)

917

45 BANKRUPTCY AND RESTRUCTURING

931

POLICIES

625

PART ONE

VALUE

627

31 VALUE AND CORPORATE FINANCE


629

PART TWO

32 VALUATION TECHNIQUES

649

MANAGING CASH FLOWS AND

PART TWO

CAPITAL STRUCTURE POLICIES

679

FINANCIAL RISKS

945

46 MANAGING CASH FLOWS

947

47 MANAGING FINANCIAL RISKS

966

33 CAPITAL STRUCTURE AND THE THEORY

OF PERFECT CAPITAL MARKETS

681

Glossary

992

34 THE TRADEOFF MODEL

693

Contents

1001

35 DEBT, EQUITY AND OPTIONS THEORY

721

Index

1009

Vernimmen.com

1037

Cribsheet


1038

36 WORKING OUT DETAILS: THE DESIGN OF
THE CAPITAL STRUCTURE

739


The 2007–2008 crisis, or rediscovering
financial risk

For some Vernimmen readers, this will be your first financial crisis. It’s not the first we’ve
seen and it won’t be the last. One thing we can be sure of, though, is that as long as
the human species continues to inhabit planet Earth, we will continue to see the rise of
speculative bubbles which will inevitably burst and financial crises will follow, as sure as
night follows day.
Human nature being what it is, we are not cold, disembodied, perfectly rational
beings as all of those very useful but highly simplified models would have us believe.
Human beings are often prone to sloth, greed and fear, three key elements for creating a
fertile environment in which bubbles and crises flourish. Behavioural finance (see p. 274)
does make it easier to create more realistic models of choices and decisions made by
individuals and to predict the occurrence of excessive euphoria or irrational gloom or to
explain it after it has occurred (which is always easier!). But behavioural finance is in its
infancy and researchers in this field still have a lot of work ahead of them.
The origin of the financial crisis that began in 2007 is a textbook case. What we
have here are greedy investors seeking increasingly higher returns, who are never satisfied
when they have enough and always want more. It’s a pity that there are people like that
about, but there you go.
So, banks started granting mortgages to people who had in the past not qualified
for a mortgage, convinced that if, in the (likely) event that these borrowers on precarious incomes were unable to meet their repayments, the properties could be sold and the

mortgage paid off, since there was only one way property prices could go and that was
up − remember? This created a whole class of subprime borrowers. Along the same lines,
LBOs were carried out with debt at increasingly higher multiples of the target’s EBITDA
(see p. 926) and with capitalised interest, as the financial structuring was so tight that the
target was unable to pay its financial expenses. This meant that virtually all of the debt
could only be repaid when the company was sold. Subprimes were introduced into high
quality bond or money market funds in order to boost their performances without altering
the description of the mutual funds. With the official approval of the regulator, bank assets
were transferred to special purpose deconsolidated vehicles (SIVs) where they could be
financed using more debt than was allowed under the regulations. Banks could thus boost
their earnings and returns by using the leverage effect (see p. 235).
In finance, risk and return are two sides of the same coin. Higher returns can only
be achieved at the price of higher risk. And if the risks are higher, the likelihood of them
materialising is higher too. This is a fact of life you should never forget or you may live
to regret it sorely (see Chapter 21).


THE 2007–2008 CRISIS, OR REDISCOVERING FINANCIAL RISK

But as long as everything is ticking along nicely, risk aversion is low and any analysis done on it becomes a superficial exercise. Nobody batted an eyelid when ABN Amro
invented a new financial product in August 2006, the CPDO or Constant Proportion Debt
Obligation, rated AAA by rating agencies as a risk-free asset that earned 2% more than
Government Bonds. Mid-2008 it was worth between 40% and 70% of its issue price,
which means that it clearly wasn’t a risk-free asset. Similarly, when discussing LBO
financing on 10 July 2007, the CEO of Citi told reporters that “as long as the music is
playing, you’ve got to get up and dance. We’re still dancing”. Finally, the market risk
premium was at its historical low at 2.86% in May 2007 (see p. 423).
But the trees don’t reach the sky, and what had to happen, happened. The mechanical
increase in the cost of mortgages written into contracts through step-up clauses triggered
the insolvency of some households, which brought a halt to the rise in property prices in

the USA, followed shortly thereafter by a fall in prices. This had a snowball effect and
millions of borrowers became insolvent. Their debts were then worth much less than their
face value. Because these debts had been introduced, like a virus, into a large number of
financial arrangements or portfolios in order to boost their performances, they contaminated their hosts in turn. By end-2008, losses linked to subprimes revealed by banks, credit
enhancers, insurance companies, hedge funds and asset managers reached over $500bn.
This was a very sudden and violent wake-up call for investors, reminding them that
risk was the other side of the returns coin. So what do they do? They head off in the
opposite direction, no longer quite as greedy but petrified out of their wits! Refusing to
subscribe or buy products that in themselves were not very complex, opaque or risky,
investors have provoked a halt in lending to subprime borrowers, they’ve brought an end
to LBOs as there is no financing available and they are responsible for deconsolidated
banking vehicles and most securitisation tools being unable to find refinancing. A liquidity
crisis, which is a crisis of confidence, has taken hold, ushering in a sharp increase in
spreads (see p. 487), leading to financing problems for companies, and especially for
banks, most of which were saved from imminent bankruptcy by nationalisation (Northern
Rock, Royal Bank of Scotland, Fortis, etc) or a fire-sale disposal (Bear Stearns, Merrill
Lynch, HBOS, etc), or an explicit government guarantee (all the others!). Only Lehman
Brothers was left to go under, and the lack of intervention was seriously regretted later as
it dramatically increased the risk of collapse of the whole financial system.
Confronted with this crisis, everybody jumped onto the deleveraging bandwagon,
especially banks and hedge funds, by selling off assets which in turn triggered a drop in
prices, and by introducing stricter prudential controls for the granting of loans. At the
climax of the financial crisis even top quality borrowers were unable to find financing.
We were inside a real credit crunch. The cost of credit shadowed the market mood, going
down when the going was good, and going up when the going got tough. In early 2007,
AA rated borrowers like WalMart could borrow at 0.35%, higher than the government
bond rate. In October 2008, the margin was at least 3.30%. Times are tough for anyone
who needs cash. The banks themselves haven’t got enough and have had to rely on government and central banks to get some (a major part of the Paulson and the other bail-out
plans).
Today, access to liquidity and financial flexibility are much more important to a company’s financial director than a hypothetical debt-driven reduction in the cost of capital.

This hypothesis has, incidentally, been called into question by Almeida and Philippon
(see p. 708) who provide figures demonstrating that the costs of debt-related bankruptcies
more or less correspond to the savings made through the tax deduction of interest. Their

ix


x

THE 2007–2008 CRISIS, OR REDISCOVERING FINANCIAL RISK

results show that the idea that carrying debt to reduce the cost of capital (an idea we’ve
never been too keen on) is in fact something of a fallacy. Has a research cycle initiated in
1958 by Modigliani and Miller come full swing?
What now?
The financial crisis is leading to an economic crisis, fostered by the deleveraging
going on in the financial world and the sharp falloff of business in the construction and
automotive sectors, the impoverishment of households due to stock exchange collapses,
and the increasing insecurity felt by everybody. As liquidity disappeared, economic activity (consumption and capital expenditure) came to a brutal halt. The record margins
registered in 2007 (European listed groups were posting operating margins of 12%) will
obviously come down (see p. 165). As most of them are carrying very little debt (see
p. 220) and given that the largest groups secured financing in 2004/2005 for 5−7 years,
they have time to reorganise themselves (except probably for some LBOs).
LBO activity, which has practically come to a standstill since the summer of 2007
(due to the lack of debt financing), will be back as LBOs are based on another type of
governance that is often better than the corporate governance in place at listed companies
and which has demonstrated its efficacy in the past (see p. 927). The leverage effect will
be lower and we’ll get back to good old fundamentals – financial expenses and a large
part of senior debt will be reimbursed using free cash flows. LBO financing is cash-flowbased, not asset-based. This slightly inconvenient truth may have been forgotten but aren’t
we lucky that we’re never too old to learn from our past mistakes?

Securitisation transactions, which make it possible to extend the field of possible
financing options and provide investors with the level of risk they’re looking for, will be
back too. But the days when banks structured operations, dished out stakes in securitisation vehicles to investors, collected a fee but didn’t take any of the risk, are well and
truly over (the “originate and distribute” model of most US investment banks). Guided by
signalling and agency theory (see Chapter 31), investors will only subscribe if they are
certain that the banks have done their jobs properly, i.e. if they have analysed and checked
the quality of the assets and the cash flows. Investors can only really be sure that this is the
case if the banks keep the riskiest tranches in their own portfolios until final repayment. If
this basic rule had been complied with, the word “subprime” would never have appeared
on www.vernimmen.com.
In the future, financial history will be written less and less in rich countries and more
and more in emerging countries. Funds provided by sovereign wealth funds (see p. 842)
with their origins in emerging countries, were like manna from heaven to the banks forced
to recapitalise following the subprime calamity (UBS, Merrill Lynch, Morgan Stanley,
Citi, Barclays, Unicredit, etc.). We doubt that these shareholders are going to remain
passive. Why should they when all research into governance has shown that shareholder
vigilance (shareholder activism even – see p. 840) is a key factor in the creation of value?
Growth in some emerging countries is flattening out or becoming negative. But over the
long term, growth will be sustainable and stronger than in the west, boosted by improving
standards of living in and the demographics of these countries. The level of risk however,
will also be higher.
Like financial crises in the past, the current crisis will come to an end.
At least two salutary lessons will have been learnt (hopefully!):
•

The extremely high payments made to the managers of corporates, banks and investment funds, without linking them to any risk, was a disastrous mistake. If an investor


THE 2007–2008 CRISIS, OR REDISCOVERING FINANCIAL RISK


•

takes a risk and earns a lot, all well and good, as that’s just one of the basic rules of
the game. But for employees to earn tens of millions of euros without having to risk
their personal assets is shocking and poses a threat to the social pact.
It is the duty of all investors to analyse the products they are investing in themselves.

And if any of you need a bit of help with that, your Vernimmen is ready and waiting with
full explanations!

xi


Preface

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

A way of thinking about finance
We are very pleased with the success of the first edition of the book. It has encouraged
us to retain the approach in order to explain corporate finance to students and professionals. There are four key features that distinguish this book from the many other corporate
finance text books available on the market today:
•

•

•

•


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

The four sections
This book starts with an introductory chapter reiterating the idea that corporate financiers
are the bridge between the economy and the realm of finance. Increasingly, they must play
the role of marketing managers and negotiators. Their products are financial securities
that represent rights to the firm’s cash flows. Their customers are bankers and investors.
A good financial manager listens to customers and sells them good products at high


PREFACE

prices. A good financial manager always thinks in terms of value rather than costs or

earnings.
Section I goes over the basics of financial analysis, i.e. understanding the company
based on a detailed analysis of its financial statements. We are amazed at the extent to
which large numbers of investors neglected this approach during the latest stockmarket
euphoria. When share prices everywhere are rising, why stick to a rigorous approach? For
one thing, to avoid being caught in the crash that inevitably follows.
We are convinced that a return to reason will also return financial analysis to its rightful place as a cornerstone of economic decision-making. To perform financial analysis,
you must first understand the firm’s basic financial mechanics (Chapters 2–5). Next you
must master the basic techniques of accounting, including accounting principles, consolidation techniques and certain complexities (Chapters 6–7), based on international (IFRS)
standards now mandatory in over 80 countries, including EU (for listed companies), Australia, South Africa and accepted by SEC for US listing. In order to make things easier
for the newcomer to finance, we have structured the presentation of financial analysis
itself around its guiding principle: in the long run, a company can survive only if it is
solvent and creates value for its shareholders. To do so, it must generate wealth (Chapters 9 and 10), invest (Chapter 11), finance its investments (Chapter 12) and generate a
sufficient return (Chapter 13). The illustrative financial analysis of Indesit will guide you
throughout this section of the book.
Section II reviews the basic theoretical knowledge you will need to make an assessment of the value of the firm. Here again, the emphasis is on reasoning, which in many
cases will become automatic (Chapters 15–24): efficient capital markets, the time value
of money, the price of risk, volatility, arbitrage, return, portfolio theory, present value and
future value, market risk, beta, etc. Then we review the major types of financial securities: equity, debt and options, for the purposes of valuation, along with the techniques for
issuing and placing them (Chapters 25–30).
In Section III, “Corporate financial policies”, we analyse each financial decision in
terms of:
•
•
•

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


Such decisions include choosing a capital structure, investment decisions, cost of capital,
dividend policy, share repurchases, capital increases, hybrid security issues, etc.
During this section, we call your attention to today’s obsession with earnings per
share, return on equity and other measures whose underlying basis we have a tendency to
forget and which may, in some cases, be only distantly related to value creation. We have
devoted considerable space to the use of options (as a technique or a type of reasoning) in
each financial decision (Chapters 31–39).
When you start reading Section IV, “Financial management”, you will be ready to
examine and take the remaining decisions: how to organise a company’s equity capital,
buying and selling companies, mergers, demergers, LBOs, bankruptcy and restructuring (Chapters 40–45). Lastly, this section presents cash flow management, and the
management of the firm’s financial risks (Chapters 46–47).

xiii


xiv

PREFACE

Suggestions for the reader
To make sure that you get the most out of your book, each chapter ends with a summary, a
series of problems and questions (a total of 798, with the solutions provided). We’ve used
the last page to provide a cribsheet (the nearly 1000 pages of this book summarised on
one page!). For those interested in exploring the topics in greater depth, there is an end-ofchapter bibliography and suggestions for further reading, covering fundamental research
papers, articles in the press and published books. A large number of graphs and tables
(over 100!) have been included in the body of the text which can be used for comparative
analyses. Finally, there is a fully comprehensive index.

An Internet site with huge and diversified content

www.vernimmen.com provides free access to tools (formulas, tables, statistics, lexicons,
glossaries), resources that supplement the book (articles, prospectuses of financial transactions, financial figures for over 16,000 European, North American and emerging countries
listed companies, thesis topics, thematic links, a list of must-have books for your bookshelf, an Excel file providing detailed solutions to all of the problems set in the book), plus
problems, case studies, and quizzes for testing and improving your knowledge. There is
a letterbox for your questions to the authors (we reply within 72 hours, unless of course
you manage to stump us!). There are questions and answers and much more. The site has
its own internal search engine, and new services are added regularly. The Internet site is
already visited by over 1000 single visitors a day.
A teacher’s area gives teachers free access to case studies, slides and an Instructor’s
Manual, which gives advice and ideas on how to teach all of the topics discussed in the
Vernimmen.

A free monthly newsletter on corporate finance
Since (unfortunately) we can’t bring out a new edition of the Vernimmen every month, we
have set up the Vernimmen.com Newsletter, which is sent out free of charge to subscribers
by Internet. It contains:
•
•
•
•

A conceptual look at a topical corporate finance problem (e.g. behavioural finance,
finance in China, carbon trading.)
Statistics or tables that you are likely to find useful in the day-to-day practice of
corporate finance (e.g. share ownership structure in Europe, debt ratios in LBOs).
A critical review of a financial research paper with a concrete dimension (e.g.
business collateral in SME lendings, the impact of pension plans on betas).
A question left on the vernimmen.com site by a visitor plus a response (e.g. what
is a debt push down? What is a subprime loan? What are economic and regulatory
capital?).


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


PREFACE

Many thanks
•
•
•
•
•

To the Deloitte IFRS MNC Advisory IFRS team, and in particular Elisabeth Baudin,
for helping us on the first part of the book.
To Thibaud De Maria, Pierre Foucry, Nance Garro, Pierre Laur, Guillaume Mallen,
Laetitia Remy, Georges Watkinson-Yull, Weikang Zhang, and students of the HEC
Paris and Bocconi MBA programmes for their help in improving the manuscript.
To Altimir Perrody, the vernimmen.com webmaster.
To Isabelle Marié-Sall for her help in transforming our scribblings into a proper
manuscript.
And last but not least to Françoise, Anne-Valérie, Enrica Annalisa and our many
friends who have had to endure our endless absences over the last year, and of course
Catherine Vernimmen and her children for their everlasting and kind support.

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

We wish you well in your studies!
Milan and Paris, January 2009
Pascal Quiry

Maurizio Dallocchio

Yann Le Fur

Antonio Salvi

xv


Frequently used symbols

AN
k
ABCP
ACES
ADR
APT
APV
ARR
BIMBO
BV
Capex
CAPM
CAR
CB
CD

CDO
CE
CFROI
COV
CVR
D
d
DCF
DDM
DECS
DFL
Div
DJ
DOL
DPS
DR
EAT
EBIT
EBITDA
EBRD
ECAI
ECP
EGM
EMTN
ENPV
EONIA
EPS
E(r)
ESOP
EURIBOR

EV

Annuity factor for N years and an interest rate of k
Asset Backed Commercial Paper
Advanced Computerised Execution System
American Depositary Receipt
Arbitrage Pricing Theory
Adjusted Present Value
Accounting Rate of Return
Buy In Management Buy Out
Book Value
Capital Expenditures
Capital Asset Pricing Model
Cumulative Abnormal Return
Convertible Bond
Certificate of Deposit
Collateralised Debt Obligation
Capital Employed
Cash Flow Return On Investment
Covariance
Contingent Value Right
Debt, net financial and banking debt
Payout ratio
Discounted Cash Flows
Dividend Discount Model
Debt Exchangeable for Common Stock; Dividend Enhanced Convertible Securities
Degree of Financial Leverage
Dividend
Dow Jones
Degree of Operating Leverage

Dividend Per Share
Depositary Receipt
Earnings After Tax
Earnings Before Interest and Taxes
Earnings Before Interest, Taxes, Depreciation and Amortisation
European Bank for Reconstruction and Development
External Credit Assessment Institution
European Commercial Paper
Extraordinary General Meeting
Euro Medium Term Note
Expanded Net Present Value
European Over Night Index Average
Earnings Per Share
Expected return
Employee Stock Ownership Programme
EURopean Inter Bank Offer Rate
Enterprise Value


FREQUENTLY USED SYMBOLS

EVA
EVCA
f
F
FA
FASB
FC
FCF
FCFF

FCFE
FE
FIFO
FRA
g
GAAP
GCE
GCF
GDR
i
IASB
IFRS
IPO
IRR
IRS
IT
k
kD
kE
K
KPI
LBO
LBU
L/C
LIBOR
LIFO
LMBO
ln
LOI
LSP

LYON
m
MM
MOU
MTN
MVA
n
N
N (d)
NASDAQ
NAV
NM
NMS
NOPAT
NPV
NYSE
OGM
OTC

Economic Value Added
European Private Equity and Venture Capital Association
Forward rate
Cash flow
Fixed Assets
Financial Accounting Standards Board
Fixed Costs
Free Cash Flow
Free Cash Flow to Firm
Free Cash Flow to Equity
Financial Expenses

First In, First Out
Forward Rate Agreement
Growth rate
Generally Accepted Accounting Principles
Gross Capital Employed
Gross Cash Flow
Global Depositary Receipt
After-tax cost of debt
International Accounting Standards Board
International Financial Reporting Standard
Initial Public Offering
Internal Rate of Return
Interest Rate Swap
Income Taxes
Cost of capital, discount rate
Cost of debt
Cost of equity
Option strike price
Key Performance Indicator
Leveraged Buy Out
Leveraged Build Up
Letter of Credit
London Inter Bank Offer Rate
Last In, First Out
Leveraged Management Buy Out
Naperian logarithm
Letter Of Intent
Liquid Share Partnership
Liquid Yield Option Note
Contribution margin

Modigliani–Miller
Memorandum Of Understanding
Medium Term Notes
Market Value Added
Years, periods
Number of years
Cumulative standard normal distribution
National Association of Securities Dealers Automatic Quotation system
Net Asset Value
Not Meaningful
National Market System
Net Operating Profit After Tax
Net Present Value
New York Stock Exchange
Ordinary General Meeting
Over The Counter

xvii


xviii

FREQUENTLY USED SYMBOLS

P
PBO
PBR
PBT
P/E ratio
PERCS

PEPs
POW
PRIDES
PSR
P to P
PV
PVI
QIB
r
rf
rm
RNAV
ROA
ROCE
ROE
ROI
RWA
S
SA
SEC
SEO
SPV
STEP
SV
t
T
Tc
TCN
TMT
TSR

V
VAT
VC
VD
VE
V (r)
WACC
WC
y
YTM
Z
ZBA
β or β E
βA
βD
σ (r)
ρ A,B

price
Projected Benefit Obligation
Price to Book Ratio
Profit Before Tax
Price Earnings ratio
Preferred Equity Redemption Cumulative Stock
Personal Equity Plans
Path Of Wealth
Preferred Redeemable Increased Dividend Equity Security
Price to Sales Ratio
Public to Private
Present Value

Present Value Index
Qualified Institutional Buyer
Rate of return, interest rate
Risk-free rate
Expected return of the market
Restated Net Asset Value
Return On Assets
Return On Capital Employed
Return On Equity
Return On Investment
Risk Weighted Assessment
Sales
Standardised Approach
Securities Exchange Commission
Seasoned Equity Offering
Special Purpose Vehicle
Short Term European Paper
Salvage Value
Interest rate, discount rate
Time remaining until maturity
Corporate tax rate
Titres de Créances Negociables
Technology, Media, Telecommunications
Total Shareholders Return
Value
Value Added Tax
Variable Cost
Value of Debt
Value of Equity
Variance of return

Weighted Average Cost of Capital
Working Capital
Yield to maturity
Yield to Maturity
Scoring function
Zero Balance Account
Beta coefficient for a share or an equity instrument
Beta coefficient for an asset or unlevered beta
Beta coefficient of a debt instrument
Standard deviation of return
Correlation coefficient of return between shares A and B


Chapter 1
WHAT IS CORPORATE FINANCE?

To whet your appetite . . .

The primary role of the financial manager is to ensure that his or her company has a
sufficient supply of capital.
The financial manager is at the crossroads of the real economy, with its industries
and services, and the world of finance, with its various financial markets and structures.
There are two ways of looking at the financial manager’s role:
•
•

a buyer of capital who seeks to minimise its cost, i.e. the traditional view;
a seller of financial securities who tries to maximise their value. This is the view we
will develop throughout this book. It corresponds, to a greater or lesser extent, to
the situation that exists in a capital market economy, as opposed to a credit-based

economy.

At the risk of oversimplifying, we will use the following terminology in this book:
•
•
•

the financial manager or chief financial officer (CFO) is responsible for financing
the firm and acts as an intermediary between the financial system’s institutions and
markets, on the one hand, and the enterprise, on the other;
the business manager invests in plant and equipment, undertakes research, hires
staff and sells the firm’s products, whether the firm is a manufacturer, a retailer or a
service provider;
the financial investor invests in financial securities. More generally, the financial
investor provides the firm with financial resources, and may be either an equity
investor or a lender.

Section 1.1

THE FINANCIAL MANAGER IS FIRST AND FOREMOST
A SALESMAN . . .
1/ THE FINANCIAL MANAGER’S JOB IS NOT ONLY TO “BUY” FINANCIAL
RESOURCES . . .
The financial manager is traditionally perceived as a buyer of capital. He negotiates with a
variety of investors – bankers, shareholders, bond investors – to obtain funds at the lowest
possible cost.


2


CORPORATE FINANCE

Transactions that take place on the capital markets are made up of the following
elements:
•
•

a commodity: money,
a price: the interest rate in the case of debt, dividends and capital gains in the case of
equities.

In the traditional view the financial manager is responsible for the company’s financial
procurement. His job is to minimise the price of the commodity to be purchased, i.e. the
cost of the funds he raises.
We have no intention of contesting this view of the world. It is obvious and is
confirmed every day, in particular in the following types of negotiations:
•
•

between corporate treasurers and bankers, regarding interest rates and value dates
applied to bank balances (see Chapter 46);
between chief financial officers and financial market intermediaries, where negotiation focuses on the commissions paid to arrangers of financial transactions (see
Chapter 30).

2/ . . . BUT ALSO TO SELL FINANCIAL SECURITIES
This said, let’s now take a look at the financial manager’s job from a different angle:
•
•
•


he is not a buyer but a seller;
his aim is not to reduce the cost of the raw material he buys but to maximise a selling
price;
he practises his art not on the capital markets, but on the market for financial
instruments, be they loans, bonds, shares, etc.

We are not changing the world here; we are merely looking at the same market from
another point of view:
•
•
•

the supply of financial securities corresponds to the demand for capital;
the demand for financial securities corresponds to the supply of capital;
the price, the point at which the supply and demand for financial securities are in
equilibrium, is therefore the value of security. In contrast, the equilibrium price in
the traditional view is considered to be the interest rate, or the cost of money.

We can summarise these two ways of looking at the same capital market in the
following table:
Analysis/Approach

Financial

Traditional

Market

Securities


Capital

Supply

Issuer

Investor

Demand

Investor

Issuer

Price

Value of security

Interest rate


Chapter 1 WHAT IS CORPORATE FINANCE?

Depending on your point of view, i.e. traditional or financial, supply and demand are
reversed, as follows:
•
•

when the cost of money – the interest rate, for example – rises, demand for funds is
greater than supply. In other words, the supply of financial securities is greater than

the demand for financial securities, and the value of the securities falls;
conversely, when the cost of money falls, the supply of funds is greater than demand.
In other words, the demand for financial instruments is greater than their supply and
the value of the securities rises.

The cost of capital and the value of the securities vary in opposite directions. We can
summarise with the following theorem, fundamental to this entire book:
Minimising financing cost is synonymous with maximising the value of the underlying
securities.
For two practical reasons, one minor and one major, we prefer to present the financial
manager as a seller of financial securities.
The minor reason is that viewing the financial manager as a salesman trying to sell
his products at the highest price casts his role in a different light. As the merchant does not
want to sell low-quality products but products that respond to the needs of his customers,
so the financial manager must understand his capital suppliers and satisfy their needs
without putting the company or its other capital suppliers at a disadvantage. He must sell
high-quality products at high prices. We cannot emphasise this enough.
The more important reason is that when a financial manager applies the traditional
approach of minimising the cost of the company’s financing too strictly, erroneous
decisions may easily follow. The traditional approach can make the financial manager
short-sighted, tempting him to take decisions that emphasise the short term to the
detriment of the long term.
For instance, choosing between a capital increase, a bank loan and a bond issue with
lowest cost as the only criterion reflects flawed reasoning. Why? Because suppliers of
capital, i.e. the buyers of the corresponding instruments, do not all face the same level
of risk.
The investor’s risk must be taken into account in evaluating the cost of a source of
financing.
The cost of two sources of financing can be compared only when the suppliers of the
funds incur the same level of risk.

All too often we have seen managers or treasurers assume excessive risk when choosing a source of financing because they have based their decision on a single criterion: the
respective cost of the different sources of funds. For example:
•
•
•

increasing short-term debt, on the pretext that short-term interest rates are lower than
long-term rates, can be a serious mistake;
granting a mortgage in return for a slight decrease in the interest rate on a loan can
be very harmful for the future;
increasing debt systematically on the sole pretext that debt costs less than equity
capital jeopardises the company’s prospects for long-term survival.

3


4

CORPORATE FINANCE

We will develop this theme further throughout the third part of this book, but we
would like to warn you now of the pitfalls of faulty financial reasoning. The most
dangerous thing a financial manager can say is, “It doesn’t cost anything.” This sentence should be banished and replaced with the following question: “What is the
impact of this action on value?”

Section 1.2

. . . OF FINANCIAL SECURITIES . . .
Let’s now take a look at the overall concept of a financial security, the product created by
the financial manager.


1/ ISSUANCE OR CREATION OF SECURITIES
There is a great variety of financial instruments, each of which has the following
characteristics:
•
•
•

it is a contract;
the contract is executed over time;
its value derives solely from the series of cash flows it represents.

Indeed, from a mathematical and more theoretical viewpoint, a financial instrument is
defined as a schedule of future cash flows.
Holding a financial security is the same as holding the right to receive the cash flows,
as defined in the terms and conditions of the issue that gave rise to the financial instrument.
Conversely, for the issuer, creating a financial instrument is the same as committing to
paying out a series of cash flows. In return for this right to receive cash flows or for taking
on this commitment, the company will issue a security at a certain price, enabling it to
raise the funds needed to run its business.
A financial security is a contract . . .
You’ve undoubtedly heard people say that the financial manager’s stock-in-trade is
“paper”. Computerisation has now turned financial instruments from paper documents
into intangible book entries, reducing them to the information they contain, i.e. the contract. The essence of finance is and will always be negotiation between an issuer seeking
new funds and the investors interested in buying the instruments that represent the underlying obligations. And negotiation means markets, be they credit markets, bond markets,
stock markets, etc.
. . . executed over time . . .
Time, or the term of the financial security, introduces the notion of risk. A debt instrument
that promises cash flows over time, for example, entails risk, even if the borrower is very
creditworthy. This seems strange to many people who consider that “a deal is a deal” or

“a man’s word is his bond”. Yet, experience has shown that a wide variety of risks can