Corporate Finance

The Vernimmen is a true bible of corporate finance. With regular updates through their monthly newsletter and upgrades, the authors have made it applicable to any place, any time.

It is sold on the understanding that the publisher is not engaged in rendering professional services and neither the publisher nor the author shall be liable for damages arising herefrom.

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.

A good financial manager listens to customers and sells them good products at high prices.

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’ve used the last page of the book to provide a crib sheet (the nearly 1000 pages of this book summarised on one page!).

And last but not least to Françoise, Anne-Valérie, Enrica and Annalisa; our children Paul, Claire, Pierre, Philippe, Soazic, Solène and Aymeric and our many friends who have had to endure our endless absences over the last years.

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.

That 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.

The most dangerous thing a financial manager can say is, “It doesn’t cost anything.”

Time, or the term of the financial security, introduces the notion of risk.

The distinction between a real asset and a financial asset is therefore subtle but fundamental.

Financial imagination knows no bounds. Keep in mind that these instruments are like the cherry on the top.

Once launched by its issuer, a financial security lives a life of its own.

Think about it: who would want to buy a financial security on the primary market, knowing that it will be difficult to sell it on the secondary market?

If not, if the company is consistently falling short of this goal, it will destroy value, turning what was worth 100 into 90, or 80. This is corporate purgatory.

Its performance depends not only on the price of copper but also on the exchange rate of the US dollar vs. the Swiss franc, because it uses the dollar to make purchases abroad and receives payment in dollars for international sales.

We are far from the CFOs of the sixties who were mainly top-of-the-class accountants!

He must be a “party-pooper”, a “Mr No” who examines every proposed investment project under the microscope of expected returns and advises on whether to reject those that fall below the cost of funds available to the company.

In 2013, worldwide, listed companies issued $191bn worth of new shares, whereas the value of shares exchanged was $52 467bn.

A company processes raw materials as part of an operating cycle, the length of which varies tremendously, from a day in the newspaper sector to seven years in the cognac sector.

The outlay on the chest freezer seems to be a prerequisite. It forms the basis for a new activity, the success of which is unknown.

Only the very puritanically minded would take more pleasure from buying a microwave than from spending the same amount of money at a restaurant!

The debt cycle is the following: the business arranges borrowings in return for a commitment to repay the capital and make interest payments regardless of trends in its operating and investment cycles.

As a result, investors forego immediate use of their funds in return for higher cash flows over several operating cycles.

Accordingly, debt represents an advance on the operating receipts generated by the investment that is guaranteed by the company’s shareholders’ equity.

If it is not positive in the long term, the company will be in trouble.

Spending money does not necessarily make you poorer. Likewise, receiving money does not necessarily make you richer.

Without wishing to philosophise, we note that the act of creation always entails some form of destruction.

Just as common sense tells us that securing a loan does not increase wealth, neither does repaying a borrowing represent a charge.

The best-laid plans may fail, while others may lead down a strategic impasse. Put another way, disinvesting is also a key part of an entrepreneur’s activities.

On the other hand, it does not differentiate between the operating and investment processes since depreciation and amortisation is not shown directly on the income statement.

The transfer of these purchases to inventory does not destroy any wealth. Instead, it represents the formation of an asset, albeit probably a temporary one, but one that has real value at a given point in time.

Spending money does not necessarily make you poorer and neither does receiving money necessarily make you any richer.

Analyse the similarities and the differences between cash and wealth, looking at, for example, investment in real estate and investment in research.

Confusion between additions to and deductions from wealth (which is an accounting issue) and cash: in the former, new borrowings do not add wealth to cover the losses.

A non-cash expense is a charge which does not reflect a specific expense, but an accounting valuation of how much wealth has been destroyed.

If you can convince your clients to pay their subscription before they get the first issue, they will basically finance the project!

According to the algebra of accounting, assets and resources (equity and liabilities) always carry the opposite sign, so the equilibrium of the balance sheet is always maintained.

If negative, it represents a source of funds generated by the operating cycle. This is a nice – but rare – situation!

Where it is permanent, the abnormal portion should be treated as a source of cash, with the suppliers thus being considered as playing the role of the company’s banker.

In a capitalist system, shareholders’ equity is the ultimate guarantee in the event of liquidation since the claims of creditors are met before those of shareholders.

Consequently, the clearly defined maturity structure of a company’s liabilities contrasts with the unpredictable liquidity of its assets.

This very often applies to most intangible assets owing to the complexity of the way in which they are accounted for.

Solvency measures the company’s ability to honour its commitments in the event of liquidation, whereas liquidity measures its ability to meet its commitments up to a certain date by monetising assets in the ordinary course of business.

But common sense tells us that a rich woman will sooner or later have cash in her pocket, while a poor woman is likely to be strapped for cash – unless she should make her fortune along the way.

But this is merely an accounting entry to deduct from operating costs, those costs that do not correspond to products sold. It has no impact from a cash standpoint.

As we shall see, it is important to remember that timing differences may not necessarily be small, of limited importance, short or negligible in any way.

Lastly, corporate income tax represents a charge that appears on the income statement and a cash payment to the State which, though it may not provide any financing to the company, provides it with a range of free services and entitlements, e.g. police, education, roads, etc.

Lastly, readers should beware of cash flow as there are nearly as many definitions of cash flow as there are companies in the world!

Net debt reflects the level of indebtedness of a company much better than cash and cash equivalents or than cash and cash equivalents minus short-term borrowings, since the latter are only a portion of the debt position of a company.

Cash on the balance sheet has increased but net debt is still the same.

No, cash flow is not a measure of increase in wealth because it does not take into account depreciation, which reflects the wear and tear of fixed assets and thus a source of wealth destruction.

This outfit is profitable the first year, and capital expenditure and increase in working capital (30 + 36) are nearly entirely paid back at end-2016 after only three years of activity. It is almost too good to be true!

The basic principle behind consolidation consists of replacing the historical cost of the parent’s investment in the company being consolidated with its assets, liabilities and equity.

Nevertheless, the definition is broader and can encompass companies in which only a minority is held (or even no shares at all!).

This is true from an economic, but not from a legal, perspective.

The equity method of accounting is more a method used to reevaluate certain participating interests than a genuine form of consolidation.

These techniques have been developed to make certain consolidated accounts look more attractive.

The buyer may be ready to pay a high price for a target just to prevent a new player from buying it, entering the market, and putting the current level of the buyer’s profitability under pressure.

As we know, goodwill has a limited lifespan in view of the competition prevailing in the business world that will, sooner or later, erode too high a profitability obtained after an acquisition.

They accept this dilution because they take the view that the size of the cake will grow at a faster rate (e.g. by 30%) than the number of guests invited to the party (e.g. by over 25%).

An entirely fictitious gain would show up in the group’s accounts if the relevant products were merely held in stock by the subsidiaries rather than being sold on to third parties.

A hyperinflationary country is one where inflation is both chronic and out of control.

The level of control is used to determine which consolidation method is applied. The ownership level is used to separate the group’s interests from minorities’ interests in equity and net income.

This chapter is rather different from the others. It is not intended to be read from start to finish, but consulted from time to time, whenever readers experience problems interpreting, analysing or processing a particular accounting item.

To accrue basically means to transfer revenue or costs from the P&L to the balance sheet.

Analysts should be aware of changes in accounting methods for construction contracts as such changes may indicate an attempt to artificially improve the published net income for a given year.

For instance, if the share price already lies well above the conversion price, the bonds are very likely indeed to be converted, so they should be treated as equity.

Deferred tax assets arising from tax losses should be recognised when it is probable that the deferred tax asset can be used to reduce tax to be paid.

It is important to recognise that deferred taxation does not represent an amount of tax currently due to or from the tax authorities, but consists of accounting entries with, most of the time, no economic underpinnings and with no corresponding cash flows.

Unlike inventories of raw materials which have been paid for and which are also a future expense, deferred tax has no monetary value.

They are, by their very nature, non-recurring. Otherwise, the group would soon not have any subsidiaries left.

The application of these principles could lead to an absurd situation.

Internally generated goodwill, brands, mastheads, publishing titles and customer lists should not be recognised as intangible assets.

For instance, what value would a top fashion house or a consumer goods company have without its brands?

To sum up, our approach to intangible fixed items is as follows: the higher the book value of intangibles, the lower their market value is likely to be; and the lower their book value, the more valuable they are likely to be.

Inventories are merely accruals (deferred costs), which are always slightly speculative and arbitrary in nature, even when accounting rules are applied bona fide.

The companies would have recognised losses in one year and then posted decent profits the next instead of resorting to all kinds of creative solutions to defer losses.

It is therefore very important to analyse off-balance-sheet items because they reflect: the degree of accounting ingenuity used by the company.

The method used to assess the actuarial value is the projected unit credit method, which models the benefits vested with the entire workforce of the company at the assessment date.

Our view is that provisions for retirement benefit plans are very similar to a financial liability vis-à-vis employees.

The whole crux of the matter boils down to whether restructuring provisions should be recorded under operating or non-operating items: the former are recurrent in nature, unlike the latter.

How then can the granting of stock options or free shares be booked as a charge? For us, this just doesn’t make sense.

Though it may be an exaggeration, we can say that they have no more value than certain start-up costs.

Since the aim of financial analysis is to portray a company’s economic reality by going beyond just the figures, it is vital to think about what this reality is and how well it is reflected by the figures before embarking on an analysis of the accounts.

Analysts’ effectiveness is not measured by their use of sophisticated techniques but by their ability to uncover evidence of the inaccuracy of the accounting data or of serious problems being concealed.

Naturally, it is impossible to appreciate the finer points of financial analysis without grasping the fact that a set of accounts represents a compromise between different concerns.

Apple, with its iPad, has created a product that is neither a PDA nor a computer but a unique product.

The famous 17th century letter writer Mme de Sévigné once forecast that coffee was just a fad and would not last for more than a week.

Conversely, tobacco, which is one of the most mature markets in existence, generates a very high level of return on capital employed for the last few remaining companies operating in the sector.

For instance, a large share of a small market is far more valuable than middling sales in a vast market.

Increasingly in our service-oriented society, grey matter is the raw material, and processing is replaced by a series of services involving some degree of added value.

A strike affecting a supplier or subcontractor may bring the entire group to a standstill.

A producer will never be efficient if the distribution network is inefficient.

If end customers slow down their purchases, it may take some time before the end retailer becomes aware of the trend and reduces its purchases from the wholesaler.

It is an ideal system when everything is going well, but highly dangerous in the event of a crisis because it exacerbates the company’s difficulties.

Financial analysts are detectives, constantly on the lookout for clues, seeking to establish a logical sequence, as well as looking for any disruptive factor that may be a prelude to problems in the future.

All too often we have seen lazy analysts look at the key profit indicators without bothering to take a step back and analyse trends.

After all, profitable companies can afford to do what they want, and some may indeed appear to be acting rather whimsically, but profitability is what really matters.

The basic idea is to prepare ratios from companies’ accounts that are leading indicators (i.e. two or three years ahead) of potential difficulties.

Prior awareness of the risk of failure (which scoring techniques aim to provide) may lead some of the companies’ business partners to adopt behaviour that hastens their demise.

Otherwise, there is no need to study the accounts, since they are not worth bothering with, and the company should be avoided like the plague as far as shareholders, lenders and employees are concerned.

20 000 chickens are anaesthetised, decapitated, processed and frozen per hour, then exported mainly to the Middle East.

In a value chain, there are positions of structural weakness, where it is better to let others invest, even if it means handling them through supply contracts.

The Financial Number Game: Detecting Creative Accounting Practices

If financial analysis were a puppet, company strategy would be pulling its strings

Sales growth forms the cornerstone for all financial analysis.

An unusually high amount may conceal problems and an effort by management to boost book profit superficially.

In the food sector, food processing companies usually establish special relationships with the farming industry. As a result, a company with a workforce of 1000 may actually keep 10 000 farmers in work.

If 100 additional staff members are hired throughout the year, this means that only 50% of their salary costs will appear in the first year, with the full amount showing up in the following period.

The emphasis placed by analysts on operating performance has led many companies to attempt to boost their operating profit artificially by excluding charges that should logically be included.

We believe it is vital for readers to avoid preconceptions and to analyse precisely what is included and what is not included in operating profit.

In large groups, closure of plants, provisions for restructuring, etc. tend to happen every year in different divisions or countries and should consequently be treated as recurring items.

An analysis of minority interests often proves to be a useful way of working out which subsidiary(ies) generate(s) the group’s profits.

A company’s accounts are littered with potential pitfalls, which must be sidestepped to avoid errors of interpretation during an analysis.

Such action is taken even though it will be another two or three years before the champagne comes onto the marketplace.

Any players opting for a more cautious approach during such periods of madness may find themselves steamrollered out of existence.

This is absolutely vital because a company that fails to sell its products or services to its customers above their cost is doomed.

Diverging trends in revenues and charges produce a scissors effect, which may be attributable to changes in the market in which the company operates.

Costs are not like problems, people do not like them to be fixed

If a company is unable to adjust its cost base, it is not a viable company.

Operating breakeven is a dangerous concept because it disregards any return on capital invested in the company, while financial breakeven understates the actual breakeven point because it does not reflect any return on equity, which is the basis of all value creation.

The closer a company is to its breakeven point, the higher its earnings instability.

The operating leverage, which accelerates the pace of growth or contraction in a company’s earnings triggered by changes in its sales performance, means that the significance of income statement-based margin analysis should be kept in perspective.

Only companies that have maintained a lean cost structure through a strategy of outsourcing have been able to survive the successive cycles of boom and bust in the sector.

In many cases, a vicious circle sets in, as the measures taken to lower breakeven trigger a major business contraction, compelling the company to lower its breakeven point further, thereby sparking another business contraction, and so on.

Its drawback lies in the fact that analysts may be tempted to overlook the company’s actual margin and concentrate more on its future, theoretical margins.

The further away a company lies from its breakeven point, the more stable its earnings and the more significant its earnings trends are.

A company’s net income, which was 0.2% of sales in year 1, leaps by 40% in year 2. State your views.

Variable costs, but they become a source of scandal when they become fixed costs.

In other words, if the working capital turnover ratio is 25% (which is high), this means that 25% of the company’s annual sales volume is “frozen” in inventories and customer receivables not financed by supplier credit.

Working capital is two-sided. From the point of view of balance sheet value, it is liquid. From a going-concern point of view, it is permanent.

Bordeaux vineyards close on 30 September, Caribbean car rental companies on 30 April. They choose these dates because that is when the working capital requirement shown on their balance sheets is lowest. This is pure window dressing.

If it is detailed enough, you can calculate true turnover ratios. If not, you will have to settle for approximations that compare dissimilar data.

To take an extreme example, imagine a company that makes all its sales in a single month. If it grants payment terms of one month, its number of days’ receivables at the end of that month will be 365.

When a company is growing, the increase in working capital constitutes a real use of funds, just as surely as capital expenditures do.

During a recession, working capital has a paradoxical tendency to grow; then, despite restructuring measures, it still doesn’t budge.

The wake-up call is pretty tough when growth slows down and payment difficulties appear.

Suppliers know that they will not have complete control over payment terms. They have unwittingly become bankers.

Be on the lookout for companies that, for reasons of hubris, grossly overinvest, despite their cash flow from operating activities not growing at the same rate as their investments.

Naturally, the risk in this situation is that the company is resting on its laurels, and that its technology is falling behind that of its competitors.

Working capital is therefore both liquid and permanent.

Any investment policy should, sooner or later, translate into increasing cash flows from operations. If not, the company will face financial difficulties.

Change your CFO or offer him a Vernimmen book!

Tell me how you’re financed and I’ll tell you who you are

If the circle is a virtuous one... the company will gradually be able to grow and, as it repays its debt, it will be able to borrow more (the origin of the illusion that companies never repay their loans).

With the development of financial markets, every division whose profitability is commensurate with its risk must be able to finance itself.

A value of 2.5 is considered a critical level, below which the company should generally be able to meet its repayment obligations.

When the value of the ratio exceeds 5 or 6, the debt becomes “high-yield”, the politically correct term for “junk bonds”.

The debt-to-equity ratio is still computed by some analysts. It is an unfortunate illustration of inertia of concepts in finance.

Analysing liquidity means analysing the risk the company will have to “borrow from Peter to pay Paul”.

The company that does so will be defenceless in the event of a liquidity crisis, which could push it into bankruptcy.

A short-term loan that finances permanent working capital cannot be repaid by the operating cycle except by squeezing that cycle down, or in other words, by beginning to liquidate the company.

But in 2013 it collapsed to €178m versus €245m the previous year pushing the debt to EBITDA ratio to 2.3 in 2013.

How would you pay off a loan in three months? You run the risk of not being able to raise new funds when your cheap loan matures.

The company is forced to call on its shareholders to bail it out.

Much ink has been spilled over the issue of whether opening or closing capital employed or an average of the two figures should be used.

Readers should pause for a second to contemplate this corporate nirvana, which apparently consists in making more money than is actually generated by a company’s industrial and commercial activities.

When the return on capital employed falls below the cost of debt, the leverage effect of debt shifts into reverse and reduces the return on equity.

The leverage effect goes into reverse once return on capital employed falls below the cost of debt.

The explanation lies in the level of debt, which is generally high for telecoms operators as it is a capital-intensive sector and lower in the automotive industry, which exhibits poorer visibility.

Just because whole chunks of capital appear to have vanished into thin air from a balance sheet perspective does not mean that shareholders will give up their normal rate of return requirements on the capital that has done a perfectly legitimate disappearing act under accounting standards.

Companies with negative capital employed usually have high negative working capital exceeding the size of their net fixed assets.

It is easy to boost book returns on equity by gearing up the balance sheet and harnessing the leverage effect.

This was the strategy of Suntech, the Chinese world leader in solar panels, which enabled it to take a lion’s share of its market, or as a consultant would put it, to move down its experience curve, but which was also the source of its collapse in 2013.

Although it may boost return on equity, it leads to an increase in risk that is proportional to the additional profit.

It’s like nirvana, high margins and low capex will generate high returns.

Group A’s improvement is merely a mirage because it is attributable entirely to a stronger and stronger leverage effect while its return on capital employed is steadily declining.

Since, by definition, a company does not undertake to repay its shareholders, its equity represents a kind of life raft that will help keep it above water in the event of liquidation.

This scenario shows how debt can spiral in the event of a crisis!

A company will be able to create value during a given period if the return on capital employed (after tax) that it generates exceeds the cost of the capital (i.e. equity and net debt) that it has raised to finance capital employed.

It may perhaps surprise some readers to see that we have often used cash flow statements in reverse, i.e. to gauge the level of earnings by working back from the net decrease in debt.

This value destruction for the year 2013 is not reflected in the market capitalisation (€1034m) being significantly above the book value of equity.

This company is on the verge of bankruptcy. This is Yell, the UK phone book company, in 2012 just before its restructuring.

The intermediary’s balance sheet and income statement thus function as holding tanks for both parties – those who have surplus capital and those who need it.

It is difficult to be wise when everybody else is behaving like a fool.

During a stock market crash, for example, a company’s share price might sink even though its published earnings exceed projections.

Imagine if every-thing could only be paid for with bills and coins!

If the fund manager does not uphold his end of the bargain, the market will lose confidence in him.

The investment bank’s trading room is where its role as “matchmaker” between the investor and the issuer takes on its full meaning.

In fact, in an efficient market, the experts’ performance is slightly below the market average, in a proportion directly related to the management fees they charge!

The premium is tantamount to a reward for putting up with illiquidity, i.e. when the market is not functioning efficiently.

There is consistent observation that stock prices perform better when the sun shines than when it rains.

This could drive an asset manager mad!

Not surprisingly their motto is “ Buy low, sell high, play golf! ”

Once a sufficient number of speculators think that a stock will rise, their purchases alone are enough to make the stock price rise.

Throughout this book, you will see that financial miracles are impossible because arbitrage levels the playing field between assets exhibiting the same level of risk.

The last of these factors probably constitutes the biggest hindrance to market efficiency because human beings cannot be reduced to a series of equations.

Small companies, since the limited number of investors interested in their shares means that their liquidity is low and that their share prices could shift away from a stable value for long periods.

J. Fuller, M. Jensen, Just say no to Wall Street: Putting a stop to the earnings game, Journal of Applied Corporate Finance, 14(4), 27–40, Winter 2002.

These are more than just tools, but actual reflexes that must be studied and acquired.

Capitalising income means foregoing receipt of it. It then becomes capital and itself begins to produce interest during the following periods.

After 20 years, a sum capitalised at 15% is six times higher than a sum capitalised at one-third the rate (i.e. 5%).

To discount is to “depreciate” the future. It is to be more rigorous with future cash flows than present cash flows, because future cash flows cannot be spent or invested immediately.

In efficient, fairly valued markets, net present values are zero, i.e. market value is equal to present value.

The higher the discounting rate, the more future cash flow is depreciated and, therefore, the lower is the present value.

The higher the discount rate, the lower the present value and net present value, and vice versa.

If instead of throwing his 30 pieces of silver away in 33 AD, Judas had invested them at 3% per annum, how much would his descendants get in 2014?

You have found your dream house and you have the choice between renting it with a lease in perpetuity for €12 000 or buying it.

Over a very long period a small change in return creates huge differences.

If net present value (NPV) is inversely proportional to the discounting rate, then there must exist a discounting rate that makes NPV equal to zero.

If the cash flow schedule is the same, then calculating the NPV by choosing the discounting rate and calculating the internal rate of return (and comparing it with the discounting rate) are two sides of the same mathematical coin.

While that is theoretically possible, it is the strong (and optimistic) form of the theory because competition among investors and the mechanisms of arbitrage tend to move net present values towards zero.

Investments with “unconventional” cash flow sequences are rare, but they can happen.

In the first case you pay €5, instead of investing it for six months as you could have done in the second.

To avoid comparing apples and oranges, a financial officer must take into account the effective date of disbursement.

Proportional rates serve only to simplify calculations, but they hide the true cost of a loan.

The internal rate of return should be handled with care, as it is based on the implicit assumption that cash flows will be reinvested at the same rate.

Is it better to make a small percentage on a very large amount or a large percentage on a small amount?

If the discount rate increases, present value will drop and will never again be equal to the market price of the investment.

For better or for worse, without risk, finance would be quite boring!

The so-called risk-free rate, to be discussed later, is simply a manner of speaking.

It sometimes requires strong nerves not to give in to the temptation to sell when prices collapse, as happened with stock markets in 1929, 1974, September 2001 and October–November 2008.

In worst-case scenarios, it must not be overlooked that some financial markets vanished entirely.

While the holder of a government bond is sure to receive his coupons (unless the government goes bankrupt!), this is far from true for the shareholder of an offshore oil drilling company.

The higher the beta, the greater the market risk borne by the security.

There is an old saying in North America, “As General Motors goes, so goes the economy”.

Only a correlation coefficient of 1 creates a portfolio risk that is equal to the average of its component risks.

As long as the correlation coefficient is below 1, diversification will beefficient.

Traditionally, this is illustrated with government bonds, even if assuming that the government cannot go bankrupt is becoming harder and harder.

To understand why, suppose that stock i was not in portfolio M. In that case, nobody would want to buy it, since all investors hold portfolio M.

The goal of the bottom-up approach is to find that rare pearl, i.e. the stock that is undervalued by the market.

Technical analysis is not based directly on any theory. It is based more on psychology than mathematics.

Short-seller funds, for example, bet that a stock will fall by borrowing shares at interest and sell-ing them, then buying them back after their price falls and returning them to the borrower.

The choice then becomes an individual one, and every investor chooses the portfolio according to his personal appetite for (or aversion to) risk.

Are you surprised by the table above? Does it prove that there is nothing to gain by geographic diversification?

The correlation between the return on these two shares is 25%.

Financial analysis contributes very little, as it must be acted upon immediately and the results seen in the share price – financial analysis kills financial analysis.

A ship in a harbour is safe but that is not what ships are built for

As his assets are not diversified, it is a matter of “life or death” for the firm that the investment succeeds.

So it is possible to have a stock that is, on the whole, highly risky but with a low β if it is only loosely correlated with the market.

A study by Campbell et al. (2001) shows that diversification is increasingly complex and that, whereas in the 1970s a portfolio of 20 stocks reduced risk significantly, today at least 50 are required to achieve the same result.

The main criticism of beta is its instability over time. It boils down a large amount of information into a single figure, and this strength becomes its weakness.

Other factors can be added to this list, including P/E, market capitalisation, yield and even past performance (which is a direct contradiction of efficient market theory).

This assumption does not fit with the efficient market theory, not only because the statistical rule for modelling prices is different but more importantly because Mandelbrot’s assumptions imply that prices have memory.

In contrast, when a recession follows a period of growth, the yield curve tends to reverse itself (with long-term rates falling below short-term rates).

Even if investors anticipate fixed short-term rates, the yield curve will slope upward due to the liquidity premiums.

In order to be more rigorous, it is necessary to discount each flow with the interest rate of the yield curve corresponding to its maturity.

An experiment was recently carried out where a child, an astrologer and a financial analyst were each given €10 000 to invest for eight years. Who do you think achieved the best results?

These types of shares are very rare and very valuable, because they go up when the market falls!

Undervalued: Imperial Tobacco, UBS. Correctly valued: Walmart. Overvalued: Volkswagen, ING.

Or “rendering what is fixed, volatile, and what is volatile, fixed”

Other methods exist, such as determining which bonds are redeemed by lottery… there is no end to financial creativity!

As a result, the nominal rate is not very meaningful.

The situation of European countries during the euro crisis has generated some peculiar cases whereby, for example, the German government could borrow at negative interest rates.

Otherwise, the price of a bond with a 15% coupon would be 115 just before its coupon payment date and 100 just after.

This cancels out the interest rate risk since the issuer of the security is certain of paying interest at exactly the market rate at all times.

The value of a fixed-rate debt instrument is not fixed. It varies inversely with market rates: if interest rates rise, its value declines; if interest rates fall, its value appreciates.

Since this forms part of a hyperbolic curve, the slope of the tangent is not constant and moves in line with interest rates.

Convexity expresses the speed of appreciation or the sluggishness of depreciation in the price of the bond if interest rates decline or rise.

From the sample of international issuers rated by Standard & Poor’s over 15 years, 0.8% of issuers rated AAA failed to pay an instalment on a loan, while 31% of issuers rated B defaulted.

If the company does not require a public rating immediately (or if it does not like the rating allocated!), it may request that it be kept confidential, and it is then referred to as a shadow rating.

Convexity, the second derivative of price with respect to interest rates, expresses the speed of appreciation or the sluggishness of depreciation in the price of the bond if interest rates decline or rise.

If you thought that interest rates were going to rise, which tranche would you choose?

It is the value of a put allowing the shareholders to sell the assets of the firm to the lenders if at maturity the value of assets is below the redemption price of the debts.

These backup lines came into their own at the end of 2008 when the commercial paper market virtually closed for several weeks following the bankruptcy of Lehman Brothers.

The documentation usually includes some stringent covenants and investors in such products may show much less flexibility than banks when it comes to renegotiation.

This type of loan is costly as it presents a significant risk for the lender. Its development is highly dependent on the activity of the mergers and acquisitions market.

Cross default clauses specify that if the company defaults on another loan, the loan which has a cross default clause will become payable even if there is no breach of covenant or default of payment on this loan.

Factoring is like discounting with additional services!

Thus, the lessee bears little or no risk if the asset becomes obsolete.

The credit agreement also specifies that the transaction is purely financial, since the borrower must repay the funds notwithstanding any disputes that may arise in the course of its business with the exporter.

In short, the whole balance sheet can be made liquid.

But it is all too easy to become intoxicated by the sophistication and magnitude of such financial structures and their potential returns.

But, of course, the greatest risk occurs during construction, since any loss can only be recouped once the facilities are up and running!

Risk exposure culminates between the end of construction and the start of operations.

A share or a stock is a security that is not redeemed – the investment can only be realised through a disposal – and whose revenue flows are uncertain.

For our purposes, this is more of a compensation for the risk assumed by the shareholder than a basic characteristic of stock.

Loyalty is (unfortunately) not a financial concept and a skyrocketing share price

Most often, a premium must be paid.

Analysts and investors in fact do not take the expected growth rate for granted. Thus, they tend to counterweight the effects of the growth rate with the robustness of these estimates.

This means that if EPS remains constant, the investor will have to wait eight years to recover his investment, while ignoring the residual value of the investment after eight years, omitting the discount and assuming that he receives all of the EPS.

Using the inverse P/E to approximate required rate of return would seriously underestimate the latter – a big mistake.

They have often been used in the past, in times of bull markets, to value Internet or biotech companies, for example, as such companies did not show a positive EBIT!

A sector cannot show equity value below book value for long as sector consolidation will soon intervene and re-establish balance, assuming that markets are efficient.

“Let’s not mix apples with oranges.” This old saying applies to the adjustment of per-share data after the detachment of rights and for free share awards and rights issues which, from a technical point of view, can modify the value of a stock.

As you have seen, the adjustment consists in rewriting past stock performance to make it comparable to today and tomorrow, and not the reverse.

However, the treasury method assumes that the best investment for a company is to buy back its own shares.

Hermès is a fast-growing company, this is reflected in its high P/E and its low dividend policy.

The haunted house, or how to pay for being frightened!

The buyer of any option has the right but not the obligation, whereas the seller of any option is obliged to follow through if the buyer requests.

Options would not exist if the future were known with certainty. In a risky environment, options remunerate the risk of an uncertain future.

When we have three investment opportunities on an underlying asset, we can always recreate the fourth, as long as we can borrow and invest in the risk-free asset!

In more concrete terms, time value represents “everything that could happen” from now until the option matures.

As an option is nothing more than pure remuneration of risk, the greater that risk is, the greater the remuneration must be, and thus the option’s value.

Since the two combinations produce the same cash flows, regardless of what happens to the share price, their values are identical.

It is based on the construction of a portfolio composed of the underlying asset and a certain number of options such that the portfolio is insensitive to fluctuations in the price of the underlying asset.

This practice is so entrenched that options market traders trade anticipation of volatility directly.

Options are like people: they run down with time.

In practice, it is impossible to create a position that is neutral on all criteria at once. No return is possible when taking no risk. No pain, no gain!

The basis of an option is the remuneration of risk. The option cannot exist in a risk-free environment and it thrives on risk.

If the legitimate ticket holder for the seat arrives before the concert starts, the holder of the Nacheinlasskart must give up his/her seat and leave the hall.

Because a 17% rise in the value of Google’s share will lead to a 133% rise in the value of the option, and a 25% drop in the value of the share will lead to a 92% fall in the value of the option.

Investors have a great appetite for novelty, especially if it gives them the feeling of doing high finance!

There being no limits to the imagination, some players have not hesitated in creating warrants on baskets of existing securities (such as indices).

In a context of rising interest rates and falling share prices, however, holders of bonds cum warrants suffer the downside risks of both debt and equity securities instead of combining their advantages.

The reader must nevertheless be wary of throwing in “free” equity warrants as a miracle remedy to ensure the success of a deal.

The option to take advantage of whichever is greater in the future – the straight bond value or the conversion value – raises the value of the convertible over both the straight bond and the conversion value.

No, there are no miracles in finance. At best, one can find mirages, and this is one.

The apparent cost of the convertible bond is low only because its true cost is partly hidden.

Convertible bonds cause expensive dilution, but it occurs when the firm can afford it!

Firms issuing this security get the tax shield of debt and keep leverage low (because preference shares are treated like equity by analysts and rating agencies).

Much of this innovation represents 'equity in drag' (Bulow et al. , 1990).

Mandatory convertibles are hybrid securities, which automatically convert into a predetermined number of shares dependent on the stock price at the time of conversion.

Many of these hybrids give the impression of lowering the company’s cost of financing. Do not believe it!

A convertible bond is like a traditional bond, generally one bearing a fixed rate, except that it also gives the holder the right to exchange it for one or more shares.

A convertible bond does not offer the same percentage of upside participation in the share price as the share itself, but in return it offers downside protection.

Bank finance was beautiful in its simplicity – whenever a company needed funds, it turned to its bank.

In any offering the bank’s exact positioning is always ambiguous.

The bank thus assumes a certain market risk. The magnitude of this risk will depend on the type of guarantee and on the timing of the commitment.

Book-building allows the banks running the transaction to limit their risk, by assuring them that investors are willing to buy the securities.

This is called a greenshoe (named after the first company to use it).

Uninformed investors cannot distinguish which issues are really attractive and thus are exposed to the winner’s curse.

The notes are presented to investors during “warm-up” meetings, which help test investor sentiment.

The bank derives high profits from its large institutional clients (in particular thanks to trading revenues). They will, therefore, favour them in the primary transactions in granting large allocations and driving the pricing down.

In a minimum-price offering, some orders may be shut out entirely, and orders at very high prices are paradoxically eliminated.

This decision is not so unusual – over 3000 foreign companies are listed in the US!

The price is set at a significant discount to the market price, so that the transaction will go through even if the share price drops in the run up to the listing of new shares.

No bank will guarantee a price near the current market price because, the longer the subscription period, the greater the risk of a drop in price.

The subscription right is similar to a call option whose underlying is the share, whose strike price is the issue price of the new shares and whose exercise period is that of the capital increase.

This is a double-edged sword as, once the deal is launched and the rights issued, nothing can delay the capital increase, even if the share price drops significantly during the deal.

The bank is then taking a significant risk and will only buy the shares at a discount to the market price.

A number of large transactions (in particular when governments are sellers) have led to heavy losses for investment banks in charge.

Shares are traded on the grey market without, technically, even existing.

Holders of convertible bonds are entitled to all information put out by the issuer to its shareholders, while the share price tells them precisely how much the CB’s option component is worth.

Membership of a syndicate sometimes even comes with the stipulation that it will be remunerated through an implicit or explicit pledge from the company to choose the bank as the lead on its next market transaction or as an advisor on its next M&A deal.

A pre-emptive subscription right is akin to a call option.

Which placement procedure carries the most risk for a bank? A bought deal, as a risk is taken that the market will change before the shares can be sold.

Why don’t issuers get upset about leaving money on the table in IPOs?

No, Sire, it’s a revolution!

An investment of 100 that always yields 15% in a market requiring a 10% return is worth 150 (100 × 15%/10%).

In doing so, he is merely giving tit for tat: an unhappy investor will sell off his securities, thus lowering prices.

Financial shortsightedness consists of failing to distinguish between cost and reduction in value, or between income and increase in value.

So why should they pay for an operation they can carry out themselves at no cost?

We must not be misled into believing that a lower degree of risk must be always matched by a lower required rate of return.

The financial investor does not want to pay a premium in the form of lower returns for something he can do himself at no cost by diversifying his portfolio.

In a way, it is the paradise that all financial managers strive for, while secretly hoping never to reach such a perfect state of boredom.

It is a real financial decision, taken freely and which may have negative financial consequences for the decision-maker if it turns out to be wrong.

Debt plays a role as well since it has a constraining effect on managers and encourages them to maximise cash flows so that the company can meet its interest and principal payments.

Maybe debt is the modern whip! This is sometimes referred to as “the discipline of debt”.

There are no impregnable fortresses, only those for which the right angle of attack has not yet been found.

Our experience tells us that taking a financial decision solely on the basis of tax considerations is rarely the right thing to do.

Financial synergies do not exist.

Can a signal be sent if there is no cash flow?

A decision can only be qualified as a signal if it is taken freely and if there is a viable alternative.

However, in practice some companies use the lack of clear guidelines and standards to choose indicators that best serve their interests at a given time, even if this involves the laborious task of changing indicators on a routine basis.

Even though ROE might look more attractive, no “real” value has been created since the increased profitability is cancelled out by higher risk not reflected in accounting data.

In a bull market, a company with mediocre economic performance may have flattering TSR and MVA.

The innovative aspect of EVA is that it identifies the income level at which value is created.

Such accounting expertise typically represents a barrier to entry for others seeking to perform the same analyses.

However, those who do not believe in market efficiency contend that MVA is flawed because it is based on market values that are often volatile and out of the management’s control.

In order to maximise value, it is simply not enough to maximise these ratios, even if they are linked by a coefficient to value or the required rate of return.

At the risk of being repetitious, a word of warning about the widespread fallacy that EPS growth equals value creation.

And yet the return on capital employed fell by 20% to 17.5%, demonstrating that this criterion is not relevant.

Financial managers typically choose those measures that will demonstrate the creation, rather than the destruction, of value.

Fortunately, there is more to life than finance. Yet in finance, there is just one overrid-ing objective – creating value – and only by meeting this objective can one achieve all the others.

If you were stranded on a desert island with only one criterion for measuring value creation, which would you want to use?

Take a concept that has existed for years, give it a new trendy name and the full media treatment and you’ve got EVA.

When it is simply a matter of deciding whether or not to make an investment, NPV and IRR produce the same outcome.

All other things being equal, decisions about projects with an NPV of zero are akin to tossing a coin in order to decide whether or not to go ahead.

It would be absurd to carry out an investment simply because the preparations were costly and one hopes to recoup funds that, in any case, have already been spent.

Theoretically, a financial manager does not view any activity as essential, regardless of whether it is one of the company’s core businesses or a potential new venture.

We recommend using after-tax valuations because a world without taxes only exists in textbooks!

A euro capitalised today in working capital can be retrieved in 10 years’ time, but it will not be worth the same.

Clearly, when the perceived risk on the investment is high, the company will look for a very short payback period in order to get its money back before it is too late!

Do you really believe that just changing an accounting method can influence the intrinsic profitability of a project? Of course not, and this example clearly illustrates the flaw inherent in the criteria.

This involves calculating the investment’s marginal contribution to the company’s cash flows; reason in terms of opportunity – i.e. in financial values and not in book values.

What problem do you come up against when calculating the payback ratio?

Why is the IRR not equal to the average of the annual returns on the project?

No, never, negative flows are part of capital expenditure in finance just as the purchase of a fixed asset is.

The cost of capital depends solely on the risk of the assets-in-place, specifically its systematic risk, since unsystematic or specific risks are not remunerated.

Since a company’s liabilities merely provide a “screen” between the asset side of the company and the financial market, the rate of return required to satisfy investors is equal to the risk-free rate plus a risk premium related to the company’s activity.

In these cases, debt then begins to behave more like equity in terms of beta characteristics.

While the arithmetic may be correct, this is totally wrong financially.

The Nestlé shareholder does not require a 16% return on book equity of CHF 62.6bn, but a 6.3% return on market capitalisation of CHF 212bn!

As a result, this reasoning has led the company to undertake the investment yielding the lower return (6% vs. 8%) for the same level of risk.

A British company investing in Russia, for example, should not use a discount rate based on British data just because its suppliers of funds are British.

Bankruptcy risk is a specific risk and not a systematic risk, and it should therefore not be taken into account by the cost of capital.

In short, in a perfect world in which investors had diversified portfolios, one man’s gain would be another man’s loss.

The only hope that they have is of providing better information to the market.

There is the possibility that the current capital allocation may not be optimal, given the co-existence of profitable divisions and a non-profitable division.

Attempting to predict the future is too complicated (if not impossible!) to be done using mathematical criteria alone.

The investor, in particular if he is not familiar with the sector (which is usually the case of financial investors) may be tempted to build a very pessimistic scenario (worst-case scenario or crash test).

Assuming that an investment is irreversible disregards the fact that corporate managers, once they get new information, generally have a number of options.

Industrial managers who have some leeway in managing an investment project are in the same position as financial managers holding an option.

If the industrial manager cannot use the additional information to modify the project, he does not really have an option but is simply taking a chance.

Thus, hanging on to it today means keeping open the option to abandon at a later date.

It tells us that the higher the underlying volatility, and thus the risk, the greater the value of an option.

According to the NPV criteria, the project destroys £3m in value and the company should reject the licensing offer. This would be a serious mistake!

The traditional net present value approach assumes that there is only one possible outcome.

In turn, these can be used to justify the unjustifiable, e.g. stock prices during the Internet bubble in 2000 or 3G licences in 2001.

The uncertainty inherent in the flexibility of an industrial project creates value, but this uncertainty declines as time goes by.

The whole problem lies in the valuation of this option (the volatility of the value of the project must be evaluated).

Nevertheless, we want to stress that valuation is not a simple use of mathematical formula, it requires the valuator to have good accounting and tax skills.

It is all right for a business plan to be optimistic – our bet is that you have never seen a pessimistic one – the important thing is how it stands up to scrutiny.

Concerning the growth rate to perpetuity, do not get carried away:

For example, if the anticipated long-term inflation rate is 2% and real GDP growth is expected to be 2%, then if you choose a growth rate g that is greater than 4%, you are implying that the company will not only outperform all of its rivals but also will eventually take control of the economy of the entire country or indeed of the entire world (trees do not grow to the sky)!

Our experience tells us that no economic profit can be sustained forever.

Some companies also perform year-end “window-dressing” in order to show a very low level of net debt.

We advise discounting savings at the cost of equity capital as they are directly linked to the earnings of the company and are as volatile (if not more so).

It also makes it easier to keep your feet closer to the ground during periods of market euphoria, excessively high valuations and astronomical multiples.

This method is not an easy one to carry out if there is regular change in the financial structure which prompts regular change in the cost of equity.

Note that we use the same value of capital employed in all three cases, as current market values should reflect anticipated changes in future operating results.

But if the cost structure of Group B remains the same in the future, its EBIT will never be positive; if that is the case, why should an investor pay a single cent for such a company?

Although it looks logical, this reasoning is flawed. Applying a P/E ratio of 25 to Valeria’s net income is tantamount to applying a P/E of 25 to Valeria’s NOPAT less a P/E of 25 applied to its after-tax interest expense.

Try to understand why the differences exist in the first place rather than to bury them in a mean or median value that has little real significance.

It makes no sense to value the land on which a warehouse has been built; it makes more sense to value the combination of the land and the buildings on it.

We will not hide the fact that this approach, while intellectually appealing, is very difficult to apply in practice, because often there is no generic “control” product to use as a benchmark.

In fact, when we say that a company has a high net asset value, it means that from a free cash flow point of view, the company’s terminal value is high compared with the value of intermediate cash flows.

A seller usually favours the DCF method as it is based upon a business plan which is rarely built on pessimistic assumptions!

Precision is the domain of negotiation, the goal of which is to arrive at an agreed price.

It is difficult to convince entrepreneurs that the roles of management and shareholders can be separated and that they must be compensated differently – and especially that the risk assumed by all types of shareholders must be rewarded.

But some industrial groups go overboard, buying companies at twice their standalone value on the pretext that their strategic value is high or that establishing a presence in such-and-such geographic location is crucial.

Some listed firms can suffer from an undervaluation due to reduced liquidity of the share, so analysts do not publish research and it then becomes a vicious circle.

The essence of negotiation lies in determining how the strategic value pie will be divided between the buyer and the seller, with both parties trying, unsurprisingly, to obtain the largest possible share.

Why can we say that the mean or the median figure is the choice of an indecisive person?

Trees do not grow until they reach the sky – ROCE cannot be higher than WACC forever.

Jumping directly to the conclusion, this part of the book could be renamed “the uselessness of the leverage effect in finance”!

In finance, everything is about the future – return, risk and value.

Voting rights are not a fourth difference between equity and debt and are only a logical consequence of the first three differences.

In a perfect market, they have no reason to pay companies to do something they can handle themselves at no cost.

This arbitrage will cease as soon as the enterprise values of the two companies come into line again.

As Merton Miller explained when receiving the Nobel Prize for Economics, 'it is the size of the pizza that matters, not how many slices it is cut up into.'

Show how you can increase this amount without altering the amount of your investment or increasing the level of risk.

No, this would be too good to be true and all companies would have huge debts.

Rather than being simply a search for value, the choice of financing is far more an endeavour to reduce conflicts of interest between shareholders and managers or share-holders and lenders.

Allowing interest expenses to be deducted from companies’ tax base is a kind of subsidy the state grants to companies with debt.

One person’s loss is another person’s gain!

Corporate managers who focus too narrowly on reducing tax charges may end up making the wrong decisions.

The value created by debt must thus be measured in terms of the increase in net income for investors (shareholders and creditors).

The explicit cost of debt is a simple yet highly effective means of controlling a firm’s management team.

The only value created by debt is the fact that it forces managers to improve enterprise value.

They put their money where their mouths are.

The pecking order is determined by the law of least effort.

LBOs create value, not on the basis of the accounting illusion of the leverage effect, but thanks to the high motivation of managers who are under pressure to repay debts.

In your view, can the theories of capital structure described in this chapter be proven with as much certainty as, say, the put/call parity described in Chapter 23 that deals with options?

A company goes bankrupt because its present and expected profits are inadequate compared with its risk, and not because it is carrying too much debt.

In The Netherlands, debt receives more favourable tax treatment, while in Tunisia, equity enjoys better tax breaks.

Corporate financing and investment decisions when firms have information investors do not have

When a company defaults, shareholders hold a “trump card” that allows them to hand the company, including its liabilities, over to the lenders.

In other words, they have “bought” the company in exchange for the outstanding amount of debt.

The lender sells the shareholders a put option at an exercise price that is equal to the debt to be repaid.

The present value of equity (8) can only be explained by the time value, which represents the hope that, when the debt matures two years hence, enterprise value will have risen enough to exceed the amount of debt to be repaid.

This is why it is so important for companies in distress to reschedule debt payments, preferably at very long maturities.

The existing creditors have lost out because they were not able to anticipate the change in corporate structure and have been harmed by the dividend distribution.

The old debt, which has become less risky, has, in fact, “confiscated” some of the value to the benefit of creditors and the detriment of shareholders.

Covenants act like an atomic bomb that aim at convincing shareholders not to spoil lenders.

And the phenomenon can pick up speed if the current lenders try and hedge their risks by selling short the firm’s shares, hoping to gain on this short-selling what they will lose as a result of the decline in the value of their debt.

This is called the expropriation effect, where some of the value of the claims is confiscated without any exchange of flows.

Time value is the hope that when the debt matures, enterprise value will have risen to exceed the amount of the debt to be repaid.

Can you give an example of a kind of company where shareholders’ equity is made up of pure time value?

The capital increase creates value for the creditors (2.1 for A and 10.1 for B), but destroys the same amount of shareholder value.

Good financing can never make up for a bad investment.

Debt can plunge the company into the ditch if its runs into difficulties; on the other hand, it can turn out to be a turbo-charger that enables the company to take off at high speed if it is successful.

If a company is successful, the cost of a share issue will appear to be much higher, as shareholders will receive much higher dividends than they initially expected.

Like insurance, equity financing always costs too much until the crisis happens, in which case one is happy to have a lot of it.

This criterion seems to us a bit outmoded, but we will address it nonetheless in a following section.

The desire to retain flexibility prompts the company to carry less debt than the maximum level it deems bearable, so that it will at all times be in a position to take advantage of unexpected investment opportunities.

A downgrade is traumatic and messy and almost always leads to a fall in the share price.

In short, it has everything a creditor craves. In contrast, an equity investor will find little to be enthusiastic about: not much growth, not much risk, thus not much profitability.

The investor will bear in mind that, statistically, his dream of multiplying his wealth through judicious use of debt will be the nightmare of the company in financial distress.

In a truly serious financial crisis, companies can no longer obtain the financing they need, no matter how good they are.

The faster growth of EPS with debt financing is a purely arithmetic result; it does not indicate greater value creation.

Companies in the same business sector often mimic each other (what matters is to be no more foolish than the next guy!).

How do you reconcile these two statements: 'You can’t make money without borrowing money' and 'Borrowing can’t create value.'

No, because it would be far too risky for a start-up, requiring certain outflows from uncertain inflows.

It’s all grist to the mill

In this context, it is very likely that shareholders will value it at less than a cent given the low return provided.

The result is that a policy of reinvesting cash flow can prove to be a time bomb for the company.

For each €1 the shareholders reinvested in the company, they can hope to get back only €0.50. Of what they put in, fully half was lost – a steep cost in terms of foregone earnings.

Beware of “cathedrals built of steel and concrete” – companies that have reinvested to an extent not warranted by their profitability!

Internal financing represents a blank cheque for managers without any control by shareholders.

The rate of growth of net profit (and earnings per share) is linked to the marginal rate of return, not the average.

Dividends do not enrich shareholders. They simply modify their wealth composition, like a transfer from the left to the right pocket.

Paying dividends is one such policy because it requires the company to have cash. A company that is struggling is not able to imitate a company that is prospering.

A good example of this attitude was provided by John Rockefeller in the 1920s: “Do you know the only thing that I like? To cash in my dividends!”

The trap for the unwitting is that internal financing has no explicit cost, whereas its true cost – which is an opportunity cost – is quite real.

What is the market’s sanction for over-reliance on internal financing?

Do you think tobacco companies have high or low payout ratios? Why? ... (but also in order to drug shareholders like they drug their customers!)

Dubai is a good example of a death spiral with a high leverage effect.

It is the shareholder who, when evaluating the company, determines the desired yield, not the other way round.

The share price of a company that pays out all its earnings in dividends will behave much like the price of a bond.

If selling the company’s shares is a “crime” – and some managers come close to regarding it as one – then a low-dividend policy is an inducement to crime.

Treasury shares lose their voting right and their right to a dividend.

If he chooses a high selling price, he will increase his proceeds provided that the shares are accepted by the company, but he reduces the probability that shares will be accepted for repurchase.

The reader who has absorbed the lessons of Modigliani and Miller and understands that cost of capital is independent from capital structure (remember “the size of a pizza is the same no matter how you slice it”?) may be indulgent.

Any change in the dividend policy raises concerns about the future evolution of the business model and creates expectations regarding the medium-term sustainability of the new level of dividends.

It also leaves unsophisticated investors believing that the stock price will go up.

A rise in the dividend signals good news; a cut signals bad news.

But make no mistake, this has only a remote association with value creation.

No, because high dividends hold down the price of the shares on which the manager holds stock options.

Why would you want to pay 200 for shares that you believe are worth 150?

The irrelevance of the MM dividend irrelevance theorem.

A share issue, which conceptually is a sale of shares at market value, has the effect of reintroducing this value-sanction via the company’s treasury, i.e. its cash balance.

A capital increase is simply a sale of shares. It implies sharing the parameters of the company.

What is new here is the conflict between old and new shareholders, under the cover of the oft-repeated hypocrisy that “we are all partners” in the same company.

If one believes in asymmetry of information, a share issue ought to be a signal that the share price is overvalued.

The anticipation mechanism operates in such a way that new shareholders will not receive an excess rate of return.

This demonstrates once again that earnings per share are not a reliable indicator of value creation or destruction.

With the wisdom that derives from experience, and notwithstanding what any theory might indicate, we could almost say that whenever P/Es are high, it is a crime for a company not to issue new shares!

The a priori negative signal that any capital increase sends – namely, that the shares are overvalued – has to be countered.

Show that if all shareholders subscribe to the capital increase, the issue price does not matter.

The commission represents the price of the put option that the company buys from the bank.

Implementing a debt policy goes beyond the simple choice of the parameters of the debt products issued or contracted, and includes the strategy of relationships over time between the firm and its various debt providers.

In a world in equilibrium, if backing a loan with an asset makes it possible to reduce the cost of financing, there is a risk that the corollary could be an increase in the cost of other financings which do not have this guarantee.

The interest rate at which the market is prepared to buy the company’s bonds, given its appreciation of the risk, is the real cost of financing the company.

The treasurer of a group may choose to tap the bond market, even if the cost is higher, so as to avoid falling into the hands of banks and to retain flexibility.

It’s taking a very big foreign exchange risk for a very small interest rate saving, it’s playing against economic theory and it is certainly not this type of activity that shareholders signed up to finance.

Under the cover of good management, he becomes a speculator, taking out debt at a floating rate when he thinks that interest rates are going to fall and at a fixed rate when he finds that current interest rates are very low.

Covenants are often the bugbear of the financial director as they are sources for reducing room for future manoeuvre.

Roberts and Sufi (2009) have shown that in the USA, the probability that a loan will be renegotiated before the end of its term is 27% for loans of less than one year, and 72% for loans of between one and three years, 94% for those between three and five years and close to 100% (98%) for those of over five years.

The liquidity crisis in the autumn of 2008 showed that cash can disappear as quickly as water in sand.

In this area, the financial director should take good heed of the advice given by Saint Matthew: “Watch ye, therefore, for ye know not the day nor the hour”.

But, like any insurance policy, flexibility has a financial cost.

A good debt policy is a policy that leaves cash on the balance sheet in order to be able to deal with the unexpected and to reduce risk, to reassure the company’s partners and to enable it to seize investment opportunities.

What is the treasurer who takes out debt over five years at a fixed rate betting on?

Accordingly you have to choose your source of instability, knowing that in accounting, fluctuations in the value of debt are only recognised, at best, in the notes to the account.

Public exchange offers are also a way for them to clean up the past, even though from a strictly financial point of view, once a company has issued a bond at a rate of 8.25% over a five-year period, regardless of what it does next, even if it exchanges it like a bond at a lower interest rate, it will continue to bear the con-sequences.

We do hope that our readers will not spend whole nights on these topics, unlike investment bankers!

Setting up a company is the riskiest segment of the economy, but also the most necessary for ensuring the renewal of economic life.

The entrepreneur does not reason in terms of probability like the financial manager. His aim is not financial. It is, above all, human.

Entrepreneurs are completely wrapped up in their adventures and can’t allow themselves to be distracted or have their timeframes dictated by debt, ticking away like a time bomb.

Better to have a small stake in a company that has had the time it needs to prove that it is viable, than a large stake in a company that is heading for bankruptcy.

We’ve seen investors pay 100 times more for their shares than the entrepreneurs, which is a considerable amount of goodwill for a company that has yet to prove itself!

He should always be thinking about his project, night and day, like a soul possessed!

In the end, an overly optimistic business plan is not in the interests of the entrepreneur, who could find himself sitting on a hand grenade from which he himself has pulled the pin!

In 2000, before the Internet bubble burst, entrepreneurs were in a strong position, but positions have been reversed and now it is investors who hold most of the cards.

This is only the flip side of the greediness of the entrepreneur, who may have insisted on the investors paying goodwill before the relevance of the concept and the viability of the business model had been proved.

Having said that, implementing this clause is very difficult because if the entrepreneur doesn’t want to sell, he will not be very convincing when trying to get a buyer to make an offer.

Drawing up a business plan that makes sense and that is also optimistic is complicated, but asking an entrepreneur to draft different versions, including one which leads to bankruptcy, is counter-productive.

If they appear to be high, it is because they integrate the risk of the start-up going bankrupt.

All of these correct arithmetical calculations assume, for these rates of return to be achieved, that reality will correspond to the projections. Now that’s another story!

For example, it is easier to recruit a good IT developer when your cash can cover 24 months of cash burn rather than three!

If goodwill is paid at the start by investors, the founders will be less diluted but they will be taking a major risk of deadlock if the business plan is not met, which is the rule rather than the exception when it comes to start-ups.