Letter number 61 of Octobre 2011
- QUESTIONS & COMMENTS
We are pleased to announce that the third edition of The Vernimmen is now available from all good bookstores and on-line retailers.
With thousands of copies of the latest edition sold, Corporate Finance, Theory and Practice has emerged as one of the most popular financial textbook, thanks to its four unique features:
• A balanced blend of theory and practice: authors hold academic positions at top ranking universities and business schools and are also investment bankers, private investors or sit on the boards of listed and unlisted companies.
• A presentation of concepts that explain situations, followed by a discussion of techniques in a direct and succinct style.
• Content enriched by the www.vernimmen.com website, which with 1,500 daily visitors, is one of the leading finance teaching sites worldwide.
• Free monthly updates on finance through The Vernimmen.com Newsletters, with over 60,000 subscribers.
The world of finance has changed a lot since the second edition (early 2009), and the new addition focuses on the consequences of the financial crisis that started in 2007, which has taken on such enormous proportions that we open the book with a development entitled “Contrasts, shocks, threats and opportunities”. The chapters on financial markets, LBOs, investments and capital structures have been thoroughly overhauled as a result of the crisis.
As most of our professional readers have recently spent a large part of their time in managing working capital, i.e. reducing it, we have create a new chapter devoted to this topics and for those who have not lost hope we also added a new chapter about IPOs.
We have also done a major updating job to create a tool that is accurate, reliable, comprehensive and relevant. We’ve included the very latest accounting standards, most statistics and graphs are from mid 2011 or end 2010, the latest innovations in financial practice are discussed (expected end of the corridor method, etc.) and the latest financial theories are presented (research into behavioural finance, etc.).
To make sure that you get the most out of your Vernimmen, each chapter ends with a summary, a series of problems and questions (827) (solutions provided). For those interested in exploring the topics discussed in greater depth, there is an end-of-chapter bibliography and suggestions for further reading, covering fundamental research papers, articles in the press and published books. A large number of graphics and tables (over 100) have been included in both the appendix and in the body of the text which can be used for comparative analyses. There are over 3,500 entries in the index.
To have a look on the contents of the 2011 edition of the Vernimmen click here and to buy the 2011 edition of The Vernimmen, click here
What they said about 2011 edition of The Vernimmen:
Corporate Finance is a very useful reference book for students and for operators who will get a great help in the present complex environment to learn the principles of the financial markets and their practical application. Written in a consequential and logical approach it shows also some interesting cases that make the study easier and stimulating.
Gabriele Galateri, Chairman of Telecom Italia
“I opened my first Vernimmen in 1982. After having spent just a few weekends reading it, I felt better equipped for my role in financial management at Paribas. Now at Apax, the Vernimmen remains my companion in my search for value creation (key in the private equity industry).”
Monique Cohen, associated director, Apax partners
“Written in a fluent and readable style and supplemented by numerous real-world examples, “Corporate Finance: Theory and Practice” has served as an excellent aid to my studies of finance. The book’s broad content has been indispensable in acquiring a better understanding of all the core areas of finance, ranging from the basics of financial analysis through to the workings of complex M&A transactions and cutting edge financial products.”
Geoffrey Coombs, student at ESCP EUROPE
"What sets the Vernimmen apart from other text books is its integration of practice and current affairs in a rigorous theoretical framework. Recipes and pontification are replaced by a scientific approach. And, thanks to the Newsletter, this is done practically in real time!"
Christophe Evers, Professor of Finance at the Solvay Brussels School, Executive Director of Texaf
"Corporate finance is a lively subject that changes from day to day and evolves regularly, depending on new market developments. 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. This is pretty unique in the field."
Mehdi Sethom, managing director, Swicorp, Head of Advisory
6. Diversification for diversification’s sake does not create value
In emerging countries, diversified groups are common as the relative lack of development of financial markets makes this form of organisation a substitute for such markets. The group allocates capital among its subsidiaries as if it were a financial market itself. But when financial markets develop, this type of organisation must prove that it is still effective. With a few examples of successful diversification (Bouygues, Berkshire Hathaway), history abounds with examples of refocusing and concentration on one business line – Schneider, Daimler, Hanson, BTR, ITT, Gulf and Western, Lagardère, Accor, etc.
Just because a company excels in one sector, doesn’t necessarily mean that it will do so in another sector, as was unfortunately illustrated by Arnault with Carrefour, Allianz with Dresdner, etc.
There are those who might be tempted to view LBO groups (Carlyle, Blackstonel, KKR, PAI, etc.) as the new diversified groups of today, but they would be suffering from an optical illusion. As the scope of LBO groups changes constantly, they do not have a business line, except the activity of selling companies using leverage and then reselling them again!
7. The cost of capital is only a function of the risk of assets
The cost of capital, a short form of the weighted average cost of capital, is the rate of return required by all of the company’s providers of funds, whether shareholders, lenders (banks, bond market, treasury market, etc.) on their funds invested in the company. In other words, the cost of capital corresponds to the reconstitution cost today, of the company’s financial liabilities and equity. As they finance the company’s capital employed, the rate of return that is generally required by the providers of funds (the cost of capital) corresponds to the rate of return to be required on the capital employed, given its risk (1) .
Tax issues have no role to play here, and believing that they do is a dangerous illusion. If all you had to do was carry a lot of debt in order to lower your cost of capital by taking advantage of the tax deductibility of interest expenses, then why do companies which are in no danger of going bankrupt carry such low levels of debt – Apple, Nestlé, Maroc Télécom, General Electric, Hermès, etc.
8. Accounting is not finance
Unlike accounting, finance takes the future – and thus risk – into account. We could even go as far as to say that finance is concerned only with the future, and that accounting, by construction is only concerned with the past. Accordingly, accounting cannot take risk into account, as risk is a dimension that does not exist in the past but that is essential to the future.
This means two things:
• that you can’t be a good financial manager if first and foremost, you are not properly mastering accountancy, so that you can understand how the past has been translated (mistranslated?) in the accounts;
• that accounting criteria, such as EPS, ROE, etc., are to be examined with precaution. A rise in these figures is not synonymous with an increase in value if it is obtained in exchange for an increase in risk which is not taken into account by the accounting criteria (see chapter 28 of the Vernimmen).
Accordingly, taking out debt to buy back one’s own shares and then cancelling them, usually results in an increase in EPS, but only corresponds to an increase in value if the shares were bought back at a lower price than their value.
9. Beware of fascination with tax issues
Nobody really enjoys paying taxes and many companies and investors spend a lot of time putting existing regulations to the best use in order to pay as little tax as possible. Our experience has shown us that this time would be put to better use if spent thinking in terms of finance rather than in terms of tax.
We have in fact often seen cases of financial decisions based on tax criteria that in the end, resulted in fundamental losses that amounted to a lot more than the tax saving made. For example, we’ve seen companies holding onto shares for a few months more after a decision has been taken to sell them, so that they can get a lower tax rate because they have held onto the shares for longer. But what happens if in the mean time, the shares lose 25% in value, like what happened this summer? Any tax gain will have been more than set off by the financial loss!
We believe that it is better to take a financial decision and then to apply it, by optimising the tax issues, and not the opposite.
10. The crisis, the only effective way of regulating capitalism
We’re all human beings with sentiments of hope and fear which results in us experiencing phases of optimism and pessimism, or in financial terms, booms and crises.
That’s just the way it is.
There have been crises in the past and there’ll be others in the future, as we wrote in the preface to the 2011 edition of the Vernimmen: “In the tempestuous world in which we live, the only certainty is the certainty of uncertainty”. Let’s not forget this and let’s act accordingly.
History gives us grounds for confidence in the future as illustrated by the trend of the French share price index since 1854:
(1) For more information, see chapter 29 of the Vernimmen.
Calculated using the 1,200 top market capitalisations worldwide ($29tr) or 55% of total market capitalisations ($53tr), this month’s graph shows:
• the triumph of self-financing which, varying from good year to bad year, accounts for 94% of the resources of the largest companies in the world;
• the increase in dividend payments to shareholders, rising from 27% to 32% of uses of funds and the insignificance, during this period, in change in working capital.
Uses of funds:
This graph is one of the new graphs created for the 2011 edition of the Vernimmen, which is now available in bookshops and from the www.vernimmen.com website.
Since an article by Ibbotson and Jaffe, published in 1975 (1) , a lot of research has been carried out on the performance of recently listed companies. Most frequently, results show that these companies over-perform in the very short term, and under-perform over a period of five years following the initial public offering (IPO). On the other hand, very little has been published on the consequences of IPOs on other companies in the sector.
Hsu et al, authors of the article that we present this month, (2) highlight the fact that IPOed companies only represent a small proportion of a diversified investor's portfolio (around 2.5%). This is why they decided to look at the performance (stock market and operational) of companies that are already listed when there is a major IPO in their sector.
On the basis of a sample of 171 IPOs announced between 1980 and 2001 (with 134 completed and 37 cancelled) (3), the study provides an empirical response to two questions.
How do the companies in the sectors in question perform?
Hsu et al show that the shares of a company react negatively to a major IPO in their sector. On the day of the announcement of the IPO, the market under-performs by 0.59%. Successful completion of the operation results in an additional loss of 0.4% (4), while the cancellation of a major IPO leads to an over-performance of 1.97% (5). Moreover, the operating performance of these companies declines in the years following the IPO, which justifies the negative reaction of the markets.
These companies are negatively impacted by the greater competitiveness of recently IPOed companies. Three additional explanations are suggested:
as a result of the IPO, the newly listed company will enjoy lower debt levels, which gives it an advantage in that it is able to react quickly and embark on profitable investment projects (at the expense of its competitors);
the certification provided by the investment banks at the time of the IPO send a positive signal to the market (compared with the older certification of already listed companies);
the IPO could bring non-financial advantages (easier to access R&D for example).
2. What features will increase (or reduce) a companies sensitivity to an IPO in its sector?
Results are consistent with the explanations set out above. Company performances suffer less of a negative impact as a result of an IPO in the same sector if:
a) the companies are carrying low levels of debt (so that they themselves will be able to react to investment projects);
b) their own IPO or capital increases were certified by a highly reputable investment bank;
c) they invest more in R&D.
The survival probability of companies when a competitor is IPOed is also greater when these three conditions are met.
Finally, by showing that companies are negatively impacted by the IPO of a competitor, the article suggests that a company that carries out an IPO, will improve its competitiveness.
(1) R.G.IBBOTSON and J.F.JAFFE (1975), Hot issue markets, Journal of Finance, vol. 30, pages 1027-1042
(2) H.G.HSU, A.V.REED and J.ROCHOLL (2010), The new game in town: competitive effects of IPOs, Journal of Finance, vol. 65, pages 495-528
(3) The sample may seem relatively small, but the authors eliminated cases where a bigger IPO was completed in the sector, in the six years following the IPO. They also focussed on non-financial sectors.
(4) Over a period running from D-10 to D+1, where D is the day of the IPO.
(5) The extent of this over-performance is not explained. We can assume that the announcement of the cancellation of a planned IPO makes another IPO in the same sector less likely in the near future.
The survival probability of companies when a competitor is IPOed is also greater when these three conditions are met.
When this question comes up, even though this is far from being systematically the case as the seller rarely gives the buyer a choice, here are a few factors to bear in mind:
1.The seller’s liquidity
When the seller sells the assets of a company, he does not directly recover the procedds from the sale. This income goes to the company since it is the owner of the assets. This situation may suit the seller if he intends to convert the company into a holding company and to reinvest the income from the sale in new activities.
If, however, the seller needs cash, for example to pay off personal debts, he would naturally prefer to get the cash directly and will thus sell the company.
Optimisation of tax issues should also be taken into account, as the tax rate on capital gains on the company’s assets, possibly combined with the tax rate on paying the cash on to the shareholder, is very unlikely to be the same as that applied to the sale of shares, nor to apply to the same taxable base.
2. The buyers tax situation
In the vast majority of cases, assets sold directly fetch a higher price than their book value which means that the buyer can depreciate them on the basis of their market value and accordingly benefit from a lower tax rate as depreciation and amortisation will be higher.
This is not possible when a company is bought, unless a revaluation of assets is carried out, which is only done when the company has large tax loss carryforwards that it is unlikely to be able to use.
Depending on the country, the purchase of assets or shares is subject to stamp duty, which has to be factored into calculations
3. Accounting issues for the buyer
These are normally neutral, since the assets acquired through a company are usually revalued at their market value (1) when they are first consolidated in the books of the buyer, as would be the same assets if bought directly.
4. Choice of perimeter
When a company is bought, all of its assets and all of its declared liabilities are acquired at the same time, unless a special agreement is reached with the seller. More specifically, without knowing it, the buyer acquires any latent liabilities that have not yet come to light.
The buyer does, of course, usually get a guarantee from the seller, but not always, and the seller will have to be solvent when the guarantee is called on. For example, we don’t believe that Barclays is unhappy that the UK Regulator prevented it from buying Lehman Brothers in September 2008, thus enabling it a few days later to acquire the assets it was interested in and not those it didn’t want, and to take over part, but not all, of the staff.
5. Legal and regulatory aspects
Sometimes a decision will be made to buy the assets or the company in an attempt to avoid having to seek administrative or regulatory authorisation, to get around a right of pre-emption or an approval right (2) . Beware, however, of abusing any rights, as the regulator is rarely the village idiot!
(1) For more information, see chapter 6 of the Vernimmen.
(2) For more information, see chapter 40 of the Vernimmen