Index

A coupon bonds, 54, 59, 68, 159, 163, 164, Abandonment, 324, 325 167 Accounting information, 349 pricing, 150, 161, 163 Adjusted present value (APV) model zero coupon bonds, 151, 152, 158, 163, 164, applying, 457 167, 181, 355 complex example, 246, 456 Booming economy, 39 Agency costs, 7, 243, 361, 439 Borrowing All-equity financed companies, 249 capital market, 97 American options, 300, 327, 328, 331 lending, 24, 55, 97, 314, 356 Annual reports, 386 possibility of, 155 Annuities Bretton Woods, 299, 455 present value, 42, 50, 51, 65 Business risk, 463, 484, 485 APT, see Arbitrage pricing theory (APT) APV, see Adjusted present value (APV) model Arbitrage pricing theory (APT), 112 C Arbitrage proof Call options example, 30, 33, 34 combinations, 306, 308, 318 Asset earning power, 104 hedging, 306 Audit, 349, 388, 393, 493 , 215, 314, 317, 324, 327, 335 Average rates of return, 113 Capital asset pricing model (CAPM) arbitrage pricing theory, 112 assumptions, 102–106 B beta value, 106 Bankruptcy costs, 226, 241, 242, 246 cost of equity, 195, 231–233 Beta value dividend valuation model, 197 adjusted, 116, 265, 272 empirical evidence, 111 estimation, 106 expression, 107 measurement, 264, 265 market line, 106–109 portfolio beta, 262, 264 summary, 110–112 Bid (selling) price, 189, 191, 193, 219, 451 validity, 113 Binomial model, 250, 324 Capital cost of, see Black and Scholes model Capital market borrowing, 97 assumptions, 314 Capital market line (CML) dividends, 314 assumptions, 102 option valuation, 300, 310, 314–317 market portfolio, 97, 103 using, 215, 314 market price of risk, 99–102 Bonds separation theorem, 225

# Springer Nature Switzerland AG 2018 495 A. Corelli, Analytical , Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-319-95762-3 496 Index

Capital rationing Covariance concept, 128 between two variables, 80, 81 calculation, 92, 104 changing, 231 Cum dividend, 195 constant, 231, 236, 238 Currency exchange, 34 earnings per share, 226, 234, 236, 237 Currency finance overseas, 432 mixed, 229, 232 Currency swaps , 241–244, 250 market, 302 trade-off theory, 241–244, 250 Current market share price, 216 CAPM, see Capital asset pricing model (CAPM) Caps (salary), 481 D Cash flows DCF, see Discounted cash flow (DCF) financing, 23, 123, 232, 368, 419 Debt guiding rules, 132 cost of convertible, 186, 216–218 investment appraisal, 122 floating rate, 334 project cash flows, 125 Debt capacity, 243, 398 CML, see Capital market line (CML) Debt capital, see Cost of debt capital Collars, 211, 308 Decision rule Company valuation internal rate of return (IRR), 122 adjusted present value model, 241 (NPV), 122 dividend model, 267, 286, 287, 292 payback period, 126 free cash flow model, 284, 286, 292 Decision trees, 130, 132–134, 145, 146, 320, Compound interest factors, 55, 156, 157 328 Constant capital structure, 231, 236, 238 Depreciation Consumption foreign exchange rates, 447 CCAPM, 110 Directors factor, 110, 260 regulation, 481 level, 110 relationship with shareholders, 234, 471, Contingent exposure, 454 474 Convertible debt Discounted cash flow (DCF) advantages, 217 assumptions, 293 cost, 218 discounted payback, 126 definitions, 217 internal rate of return (IRR), 122 Core activities, 7 net present value (NPV), 122 Corporate tax Diversification, 82, 87, 93, 102, 103, 109, 118, rate, 151, 230, 231, 247, 250, 253, 266 263, 268, 269, 343, 432, 439, 440, 456, Corporate taxation, 210, 247 460, 463, 468, 493 Cost of debt capital Dividend growth model, 194, 198, 201, 292 fixed rate debt, 231 Dividend growth rate impact of corporation tax, 179 changing, 194 opportunity cost, 123, 232 Dividends semi-annual interest payments, 216 Black and Scholes model, 215, 324 Cost of equity capital patterns, 200 capital asset pricing model (CAPM), 195, as residual, 13, 364, 367 201, 233, 258, 266 as signals, 236, 399 dividends, 201 valuation model and, 197, 199 market price, 194, 195 Dividend valuation model (DVM) Country risk, 442 bid and offer prices, 191 Coupon bonds vs. CAPM, 102 pricing, 54, 159, 164 cum dividend, 195 Index 497

dividend patterns and, 200 Foreign exchange (FX) markets ex dividend, 235 discounts and premiums, 455–457 DVM, see Dividend valuation model (DVM) exchange/delivery of currencies, 450, 454, 455 forward, 451, 453, 455 E rates of depreciation and appreciation, 456 EPS, see Earnings per share (EPS) spot, 452–454, 460 Equity capital, see Cost of equity capital swap, 451 European options, 300, 331 Foreign exchange (FX) rates Exchange rates foreign, see Foreign exchange buying and selling, 451, 452 rates cross rates, 460 Ex dividend, 194, 195, 235, 314, 328 determinants, 450 Exercise prices, 213–215, 321, 324–326, 331 forecasting, 453, 460 Expected returns inflation, 459 risk and, 96, 100, 102, 104, 108, 112, 115, interest rates, 457, 458 260, 441 Forward FX market Expected utility vs. FX futures market, 453, 455 individual choice amongst risky, 191 Forward interest rates, 447, 448 investors’ behaviour axioms, 191 Fundamental analysis, 234, 278, 284–289, 443, risk and, 191 488 utility function, 110 Futures contracts, 189, 300, 301 FX, see Foreign exchange (FX) FX options contracts F over-the-counter options, 452 FDI, see Foreign direct investment (FDI) traded currency options, 302 Financial decisions conditions, 43 types of long-term finance, 419 G value base, 6 Gambles, 69, 146, 262, 360 Financial investments, 147, 244, 297 Gamma of a call option, 318 Financial lease Gearing evaluating, 365 up, 457 Financial markets market efficiency, 451 share dealing, 344 H term structure of interest rates, 58, 485 Hedging, see Foreign exchange hedging; Financial risks, 114, 156, 298, 299, 484, 485, Transaction risk hedging 487, 488 Hirshliefer separation theorem, see Separation Fisher effect, 449 theorem Floating rate debt, 334 Floor, 218, 237, 303, 306, 355, 450, 481 Foreign currency options, 455 I Foreign direct investment (FDI) Incremental cash flows domestic vs. foreign projects, 434 IRR and, 126 economic risk, 434 Inflation Foreign exchange (FX) hedging foreign exchange market, 447 contingent exposure to FX risk, 454 real and market rates of interest, 162 traded options vs. OTC options, 306 Insiders, 351, 437, 489 transaction risk, 454 Interdependent projects, 326 translation risk, 455 Interest coverage ratio, 22 498 Index

Interest rate Long-term finance, 339–369, 371, 407, 419 collars, 211 Low coupon bonds, 167 floors, 355 foreign exchange market, 445, 447, 457, 458 M Interest rate futures Management charges, 146, 301, 388, 393 hedge efficiency, 301 Margin, 9, 18–21, 26, 38, 81, 110, 111, 143, Interest rate risk 188, 190, 207, 220, 226, 230, 241, 259, interest rate futures, 301 264, 280, 303, 383, 387, 397, 456, 457, Internal rate of return (IRR) 479, 485 decision rule, 122, 125–126 Marginal rate of return, 111 incremental cash flows, 125 Market efficiency, see Efficient market model, 60–62, 125–126 hypothesis (EMH) NPV vs. IRR, 60 Market portfolio Intrinsic value assumptions, 103, 441 determinants, 206 risk, 106, 262, 433, 441, 442 Investment, 262 Market price building blocks, 33 of risk, 99–102, 113, 310 decision, 129, 131, 225, 243, 320–322, 326, Market rate of interest, 44, 45, 58, 154, 155, 410, 445, 454 172, 457 expected returns, 73, 89, 108, 110, 114, 232, Maturity mismatch, 383 260 Maturity of option, 79, 153, 212, 316, 321, 325, financing decision, 6, 239, 432, 484 330 physical, 12, 325 Mixed capital structure companies, 369 put options in the shares, 305, 307 Money markets, 353, 375, 400, 439 return on investment, 278, 292 Multi-asset portfolios risk, 127, 411 three-asset portfolio, 115 risk and expected utility, 110, 191 Mutually exclusive investments, 124 risk-free, 113, 127, 258, 259, 325, 447 Mutually exclusive projects, 122, 123, 126, 129 risk-free bonds, 31, 181 risk-free portfolio, 97, 98, 103, 441 shares, 33, 187, 190, 191, 197, 218, 227, N 237, 254, 282, 414, 438, 464, 474 Net present value (NPV) Investment appraisal calculating present values, 59–60 adjusted present value (APV), 244–246 decision rule, 122–125 changing capital structure, 224, 225, 227, discounting, 125, 329 242, 243 NPV vs. IRR, 60–62, 125 financing cash flows, 122 and inflation, 147, 154 payback method, 126–127 O return on capital employed, 252 Offer price, 189, 191, 414, 428 Investors Operating lease, 364, 365 behavior, 30, 112, 483 Opportunity cost of debt capital, 123, 232 individual choice, 98, 127, 145, 375, 400, Option contract markets, 79, 321 458 Option exchange market, 306 Option hedge setting up, 99, 306 Option valuation L binomial model, 310–313, 324 Leasing, 353, 360, 364–369 Black and Scholes model, 310, 314–317 London Exchange, 353 building blocks of investment, 321, 322 Index 499

characteristics, 324 Pricing bonds, 161, 163 ‘Greeks’, 317–320 Probability, 39, 83–85, 88, 131–133, 145, 146, intrinsic value, 206 169, 191, 231, 303, 310–313, 318, 334, market value, 315 335, 358, 410, 433, 476, 489, 491 premium, 306 Profits, 2–4, 6, 8, 9, 15, 17–21, 26, 29, 31, put-call parity theorem, 322 33–35, 37, 54, 55, 67, 74, 112, 118, 121, real options, 310–321 127–130, 139, 145–147, 153, 175, 181, summary, 333 185, 190, 207, 211, 215, 227, 231, 234, terminology, 310–320 238, 242, 252, 277, 281, 282, 286, 290, time value, 313 299, 304, 306, 322, 323, 345, 349, 350, using share options, 315 366, 368, 371, 374, 380, 381, 384, 386, Option writer, 306 406, 410–413, 415, 416, 431, 434, 437, OTC, see Over-the-counter (OTC) 440, 445, 451, 457, 464–467, 471, 474, Overseas currency finance, 432 477, 479, 484, 486, 487, 489 Project cash flows inflation and IRR rule, 125 P investment appraisal, 122 Payback method Project risk weighted average cost of capital advantages, 127 (WACC), 230, 232, 233 decision criterion, 126, 127 Put options disadvantages, 126 combining with calls, 308, 313, 316, 331 discounted, 127 valuing, 314, 324 time value of money, 126 working capital, 126 Pecking order theory Q consideration of debt, 242 financing dilemma, 241 Quality spread, 136 market signals, 243 rules, 242 Perpetuities, 41, 42, 48–52, 62–68, 197, 198, R 201, 240, 273, 280, 288, 327 Random walk, 169 Personal taxes, 242, 246–249 Rate of interest, 172, 301, 363, 381 Physical investment, 12 Real options, 297–333, 461 Political risk, 438, 460 Real rate of interest, 323, 433, 449 Pool of funds concept, 368 Redemption, 25, 356, 398 Portfolio betas, 108, 109, 115 Regulations Portfolio theory audit, 349 capital market line, 97 directors’ transactions, 349, 481 diversification within companies, 102, 109, ineffective, 481 268, 343, 432, 468 reports, 281, 282, 303, 366, 481 multi-asset portfolios, 114 stock exchange rules, 210 risk-free investment, 96–98 and mergers, 398, 464, 465 summary, 113 Required return on equity capital two-asset portfolios, 97 changing, 233, 433 Potential decision maker, 328 Return on investment, 54, 68, 90, 155, 278, 292 PPPT, see Purchasing power parity theorem Rho of an option, 317, 319 (PPPT) Risk Present value of annuity, 42, 50, 51, 65 abandonment decision, 321, 324, 325, 335 Present value calculation, 42, 49, 59–66 country/political, 56, 154, 259, 438, Present value factors, 127 440–442, 447, 460 500 Index

Risk (cont.) S downside, 265, 457, 478 Security market line (SML) economic, 57, 150, 252, 440, 453 and capital market line (CML), 102, 107, expected NPV, 61, 62, 123, 124, 130, 246 114 expected return and, 30, 73–88, 92, 96, 100, derivation, 107 104–106, 110, 112, 115, 260, 324, 432, Segmented markets, 16, 272, 303, 442, 469 441 Semi-annual interest payments, 216 expected utility model, 93, 110, 191 Shareholder financial, 73, 114, 156, 298, 299, 484, 485, and market, 8, 35, 236, 238 487, 488 regulation, 211 individual choice, 260, 341 (see also relationship with directors, 234, 235, 349, Interest rate risk) 471, 474 investment, 56, 73, 74, 92, 97, 100, 104, value, 237 108, 113, 127, 129, 131, 150, 153, 154, wealth, 126, 128 225, 243, 260, 262, 264, 268, 297, Share options 320–322, 325, 326, 333, 341, 342, 366, combining calls and puts, 300, 305 410, 445, 454, 468 speculating with calls, 306, 307 investment decision, 74, 129, 131, 225, 243, speculating with puts, 306, 307 320, 322, 326, 410, 445, 454 writing/selling, 306 market portfolio, 97, 98, 103, 104, 106, 115, Share price volatility, 209 264, 440–442 Single-owner firm, 465 market price, 2, 99–102, 113, 310 Single-period capital rationing overestimating, 262 and IRR, 129 return and, 73–113, 117, 119, 137, 264, 342, mutually exclusive investments, 129 383, 399, 440, 441 Single-period investment-consumption model, sensitivity analysis, 165, 320 see Investment-consumption model summary, 112, 113 SML, see Security market line (SML) systematic/unsystematic, 102, 103, 106, Spot FX market, 451, 452 109, 116, 262, 270 (see also Transaction Spot interest rates, 448 risk hedging) Stock exchange rules, 210, 214, 271, 290 translation, 454, 455 (see also Uncertainty) Stock market underestimating, 268 analysis, 186, 193 Risk-adjusted discount rate secondary, 189 certainty-equivalents, 197, 252 workings of, 186 risk and return, 127 Supply and demand, 30, 31, 56, 190, 218, 301, Risk-adjusted WACC, 229, 230, 232, 254, 273 325, 352, 392, 394, 444 Risk-averse, 98, 260, 261, 263, 398, 440, 441, Swaps, 12, 153, 300–302, 334, 452, 455 444, 487 Risk-free bonds, 36, 118, 150, 154, 247, 258 Risk-free investment T borrowing possibility, 97, 98, 104, 151, 154, Taxation 188, 259, 314 capital structure, 223, 225, 226, 228, 236, combined borrowing/lending, 13, 97, 98, 238, 242, 246–250, 253, 354, 438 314 dividend considerations, 5, 210, 238 portfolio, 97, 468 foreign projects, 456, 457 possibilities, 118 weighted average cost of capital (WACC) riskless asset plus risky portfolio, 98 and, 229–231, 233 risky-riskless boundary, 31, 33, 99 Technical analysis, 142, 187 two-asset portfolio, 35, 36, 97, 114 Term structure of interest rates Risk-reduction effect, 381 spot interest rates, 448 ROCE, see Return on capital employed yield curve, 162–164, 169, 178, 179 Index 501

yield to maturity (YTM), 118, 150, V 159–161, 165, 179, 180 Vega of a call option, 319 Theta of an option, 317, 319 Time horizon, 50, 67, 75, 88, 105, 113, 127, 130, 192, 233, 273, 285, 311 W Time to maturity, 152, 165, 213, 317, 319, WACC, see Weighted average cost of capital 324–326, 332 (WACC) Time value of money (TVM) WDA, see Writing-down allowance (WDA) discounting process, 44–46, 49, 66, 178, Weak efficiency, 35, 37, 380, 471 199, 216, 274, 280, 325, 381 Wealth net present value (NPV), 59–60, 67 shareholder, 380, 456, 474, 476 Time value of option Weighted average cost of capital (WACC) time to expiry, 213, 300, 317, 331 assumptions, 229, 231 volatility of share price, 155, 209 project discount rate, 228 Total market value model, 232 project risk and, 229, 230, 233 Traditional valuation model, 203, 210, 320, 410 risk-adjusted, 233 Transaction costs, 31, 32, 35, 186, 226, 235, taxation and, 230, 233 246, 252, 263, 314, 375, 419, 420, 439 Writing (selling) options, 16, 306 Transaction risk hedging Writing-down allowance (WDA), 15 swaps, 301, 302 Translation FX risk, 450–455 TVM, see Time value of money (TVM) Y Two-asset portfolios Yield curve, 58, 149, 150, 162–164, 169, covariance, 91, 92, 109 177–179, 211, 219, 220, 231 risk and expected return, 82, 83 Yield to maturity (YTM), 53, 54, 68, 118, 150, risk-free investment, 97 159–161, 165, 180

U Z Uncertainty, 373 Zero coupon , 151, 152, 158, 163, 164, impact, 130, 321, 373 167, 181, 355 simple approach (see Unsystematic risk) Zero sum games, 191 Utility function shape, 108