Kevin Boakes - Reading and Understanding The Financial Times - Updated For 2010-2011-Financial Times Prentice Hall (2010) 2

“The Blog in general provides an excellent “As a BA (Hons) Business Studies student it is
Reading and Understanding the

additional resource. It is an excellent complement “An excellent learning tool, bringing real-world examples to a very wide range of key useful to read the Financial Times. This can be
for someone studying independently, for example
a distance-learning student. It would also be very
financial concepts, the book brings financial theory to life and makes the FT articles
accessible to everyone. Very clear explanation of what really happens in financial Reading and Understanding the very daunting, but the textbook Reading and
Understanding the Financial Times helps to
Financial Times
useful for part-time students.” markets – an excellent practical introduction to corporate finance.” explain it and make it a lot more accessible.”
John Gannon, University of Northampton Eoghan Harrington, Investment Banker Micha Bailey, South East Essex College
“This book has a unique approach to delivering “This book is an excellent choice for finance professionals or those who just enjoy reading “Reading and Understanding the Financial Times
key finance content for teaching purposes. It the finance section of the paper to get an understanding and engage in some of the more gave me an easier way to make sense of those
strongly links ‘key terms’ in finance to real life, topical and complex financial issues. The use of current events as a learning tool sets it articles, which were hard for me to understand.
which is especially helpful for students with
a strong desire to know more about the ‘real’
apart from other books and puts you in the middle of a discussion on financial theory.”
Brian Shaw, Finance Director, LEGOLAND, California
Updated for 2010–2011 It shows a great organisation with realistic
examples and analysis to these cases. I will
corporate finance world and to pursue a career highly recommend this book to those who begin
in this area.” their study in finance and business subjects! It’s
really amazing!”
Dr Liang Han, University of Hull
Updated for 2010–2011
FINANCIAL TIMES
Biyu Chen, Edinburgh Napier University
Do you want to read and understand the FT with confidence?
“If you have ever opened up the Financial Times Do you work in Finance? Do you want a career in Finance?
and felt overwhelmed by all the jargon then “This book played an instrumental roll in
this book is for you. Knowledge gleaned from Then this is the book for you! landing me various placements at international
reading this book would also prove very useful Reading and Understanding the Financial Times analyses a selection of topical FT articles with law firms. I would definitely recommend this
to students applying for jobs in the city.” recurrent themes relating to some of the most important issues in the world of corporate finance, book to anyone who needs to learn about the
Jack Kinsella, Director, Hermes Technologies leaving you ready to conduct your own analysis the next time you read the FT for business or pleasure. corporate world. Fantastic!”
Limited Ramandeep Kaur, Oxford Law Graduate
NEW! Eight new articles ranging from Woolworth’s unsuccessful fight for survival
“There are so many books covering the same to high profile companies issuing stark profit warnings, investors exercising their rights “As a BA Accounting and Finance student, this
topics in too much detail from an academic and the UK and US governments’ responses to the banking crisis. book is amazing and has helped me revise for my
perspective. Reading and Understanding the NEW! Enhanced topic introductions explain in simple steps the financial theory finance module with much ease. This book is ideal
Financial Times does not pretend that it is yet behind the articles and analysis. for any student who is currently studying Finance
another book on corporate finance. Its different or someone who works in Finance.”
2010–2011
Updated for
approach and writing style – practical and NEW! Extended research sections provide more suggestions for further reading.
Amy Shidu, London
hands on, woven around FT articles – is its NEW! The secret places inside the Financial Times. Unfold the section in the front
principle strength.” of the book to reveal the importance of six key features in the FT. Understand what to
Martin Silberstein, Leeds Metropolitan University look for and unravel the mystery of the data once and for all.
Kevin’s blog
Visit www.pearsoned.co.uk/boakes for the author’s regularly updated blog with
Boakes
his take on the day’s business news as it unfolds. Download podcasts to listen to
at your leisure.
Visit our website at

www.pearson-books.com
Cover image:
Kevin Boakes
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Reading and Understanding the
FINANCIAL TIMES
Updated for 2010–2011
Kevin Boakes
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Pearson Education Limited

Edinburgh Gate
Harlow
Essex CM20 2JE
England
and Associated Companies throughout the world
Visit us on the World Wide Web at:

www.pearsoned.co.uk
First published 2008

Second edition published 2010
© Pearson Education Limited 2008, 2010
The right of Kevin Boakes to be identified as author of this work has been asserted by him in accordance
with the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording or
otherwise, without either the prior written permission of the publisher or a licence permitting restricted
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All trademarks used therein are the property of their respective owners. The use of any trademark in this
text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor
does the use of such trademarks imply any affiliation with or endorsement of this book by such owners.
ISBN 978–0–273–73181–8
British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data

Boakes, Kevin.
Reading and understanding the Financial times / Kevin Boakes. — 2nd ed.
p. cm.
ISBN 978-0-273-73181-8 (pbk.)
1. Corporations—Finance. I. Financial times (London, England) II. Title.
HG4026.B596 2010
338.4’3—dc22
2009039558
10 9 8 7 6 5 4 3 2 1
13 12 11 10 09
Typeset in 9/13pt 2Stone Sans by 3
Printed in Great Britain by Henry Ling Ltd., at the Dorset Press, Dorchester, Dorset
The publisher’s policy is to use paper manufactured from sustainable forests.

A01_BOAK1818_02_SE_FM.QXP:M00_BOAK1818_02_SE_C00 3/11/09 08:16 Page v
To my Mum and Dad with thanks for all their support.

A01_BOAK1818_02_SE_FM.QXP:M00_BOAK1818_02_SE_C00 3/11/09 08:16 Page vi
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Contents
About the author xiii

Preface xiv
Online web content xvi
The podcasts xvii
A message to readers . . . xviii
A message to teachers . . . xix
Acknowledgements xx
Publisher’s acknowledgements xxi
Topic 1
Introduction to corporate finance 1
Poor communications puts Sports Direct off track

Article 1 Sports Direct warning stumps investors 5
Lucy Killgren and David Blackwell
Financial Times, 27 April 2007
Activist shareholders demand change at Logica

Article 2 Logica’s chief quits in wake of warning 9
Roger Blitz
Financial Times, 28 May 2007
Article 3 Investors expecting change at LogicaCMG 10
Maija Palmer
Not so easy for Sir Stelios!

Article 4 Sir Stelios spells out fears for easyJet 15
NEW! Kevin Done
Financial Times, 24 November 2008
Topic 2
Financial institutions featuring investment banks 21
Financial markets watch the new Fed chairman

Article 5 Bernanke to give a taste of more transparent Fed 24
Andrew Balls
Financial Times, 14 February 2006
vii
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Contents
The roller-coaster life of an investment banker

Article 6 How long can the good times last? Bankers cautious despite bids
and bumper bonuses 32
Peter Thal Larsen
Article 7 JPMorgan to cut prop trading desk 36
NEW! Francesco Guerrera, Justin Baer and Jeremy Grant
More transparency needed at the Bank of England

Article 8 Bank to give better guidance over rates 40
Chris Giles and Scheherazade Daneshkhu
Topic 3
Financial markets 47
At 1.30 p.m. in London all eyes are on the screens

Article 9 Surprising US job creation data rally stock markets and dollar 49
FT reporters
Financial Times, 2–3 June 2007
Financial markets standing at a crossroads

Article 10 Bond yields spark credit concerns 54
Michael Mackenzie, Richard Beales and Joanna Chung
Financial Times, 8 June 2007
Article 11 Bond market sell-off 55
Lex column
Topic 4
Debt finance 61
Greek government launches new bond issue

Article 12 Athens prepares 50-year bond issue worth €500 m–€1 bn 64
Kerin Hope
Financial Times, 18 January 2007
Japanese convertibles back in fashion

Article 13 Convertibles stage a return to fashion 70
David Turner
viii
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Contents
Bulldog, Yankee and samurai bonds . . .

Article 14 Record samurai deal by Citigroup 75
Mariko Sanchanta
Financial Times, 6 September 2005
European bond markets start to diverge

Article 15 Flight to liquidity pushes Eurozone bond yields apart 79
NEW! Joanna Chung
Topic 5
Capital structure 87
MyTravel on the brink

Article 16 MyTravel shareholders offered 4% in £800 m debt-to-equity
restructuring 90
Matthew Garrahan
Financial Times, 14 October 2004
Blacks Leisure hit by global warming

Article 17 Blacks Leisure falls into the red 94
Tom Braithwaite and Maggie Urry
Looking for the ‘right’ way forward

Article 18 UK investors dig in over pre-emption rights 98
NEW! Kate Burgess
Topic 6
Equity finance 105
Hargreaves’ founders float all the way to the bank

Article 19 IPO values Hargreaves at £750 m 109
Sarah Spikes and Lina Saigol
Article 20 Hargreaves Lansdown soars on debut 110
Sarah Spikes
Good value at Sainsbury’s?

Article 21 Valuing Sainsbury’s 114
Lex column
ix
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Contents
As Woolworths died we try speed-dating for the last time!

Article 22 Woolies investor opposes sale 118
NEW! Tom Braithwaite
Topic 7
Stock market efficiency 123
Company shares split down the middle

Article 23 Stock splits: time to query decades of dogma 126
John Authers
Topic 8
Private equity finance featuring management buyouts 131
Private equity firm fills its Boots

Article 24 Boots provides takeover acid test 134
Chris Hughes, Tom Braithwaite and Andrew Taylor
Financial Times, 21–22 April 2007
Economic slowdown provokes unease at private equity firm

Article 25 3i chief Yea quits following steep fall in shares 141
NEW! Martin Arnold
Topic 9
Dividend policy 147
Have share buybacks gone too far?

Article 26 Shareholders taking a stand on handouts 150
Chris Hughes
Financial Times, 19–20 May 2007
Printing money pays big dividends for De La Rue

Article 27 De La Rue pays special dividend 155
Tom Griggs
Topic 10
Mergers and acquisitions 159
x
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Contents
Sophisticated European company into hot metal seeks more sympathetic

partner . . .
Article 28 Discussions unlikely to yield white knight 162
Mariko Sanchanta
Article 29 Mittal goes on Arcelor charm offensive 163
Peggy Hollinger
Can Japanese sauce spice up US hedge fund?

Article 30 Poison pill’s strength under analysis 167
Michiyo Nakamoto
Topic 11
Risk management and hedge funds 173
The $2 pound puts pressure on UK companies

Article 31 Exporters curse dollar’s drag on profits 177
Chris Hughes
So tell me, what do these hedge funds actually do?

Article 32 Facing down the threat of tighter rules 184
James Mackintosh
Topic 12
Bank failures featuring Northern Rock and Citigroup 191
Bank 1: Northern Rock: the road to nationalisation

Article 33 Fresh turmoil in equity markets 194
Krishna Guha, Michael Mackenzie and Gillian Tett
Financial Times, 11–12 August 2007
Article 34 Repo market little known but crucial to the system 196
Michael Mackenzie
Article 35 Growing sense of crisis over interbank deals 197
Gillian Tett
Article 36 Bank throws Northern Rock funding lifeline 200
Peter Thal Larsen and Neil Hume
xi
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Contents
Article 37 Brown saw no other option 203

NEW! George Parker and Peter Thal Larsen
Bank 2: Back in the USA, the government acts to save Citigroup

Article 38 US government agrees to take biggest single stake in Citigroup 205
NEW! Francesco Guerrera and Alan Beatte
Glossary 213
Index 233
xii
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About the author
After graduating with a degree in Economics and an MSc from

the London School of Economics, Kevin Boakes started his
working life on the bond trading desk at Greenwell Montagu
Gilt-edged, which is now part of HSBC Investment Bank. As their
Chief UK Economist he was responsible for giving on the spot
advice to bond traders as soon as economic stories hit the news
screens. He regularly contributed articles to newspapers
including The Times, Observer and Guardian and appeared on the
BBC’s Money Programme and the Financial World Tonight. In the
late 1980s he decided to make a radical career change and left
the City to join Kingston University, initially in the Economics
Department and then at Kingston Business School where he is currently a Senior Lecturer
in the School of Accounting and Finance. He teaches both undergraduate and postgrad-
uate courses in Finance and International Financial Markets. In addition to his academic
work he has run a number of economics and financial market training courses for various
investment banks.
xiii
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Preface
What this book does

This text incorporates a selection of articles from the Financial Times that relate to some of
the most important issues in the world of corporate finance. The main focus of the book
is to provide a brief analysis of each article, explaining how the subject matter reflects a
topic which will form a key part of any corporate finance course.
The articles have been selected because:

They include substantial corporate finance content in addition to key concepts and/or
specific financial market terms that need to be explained to those unfamiliar with this area
of finance. They contain topical subjects and at the same time include themes that recur
regularly in the Financial Times so that, once the reader has worked through the analysis
in the book the Financial Times will become more accessible. The reader acquires transfer-
able skills, which they can then use when they engage with corporate finance in any
context such as television, radio reports, the internet or finance journals. Readers will learn
how financial theory relates to the reality of the business world.
It provides the opportunity for self-study

This is a book that can be used by students with minimal or even no formal teaching input.
As a result it is ideal as a basis for self-study ahead of normal teaching activities such as
seminars, lectures and exams.
A useful classroom resource

The book is also invaluable for lecturers to use as part of their teaching programme. For
each article a series of activities is included that can be set as seminar work for students to
complete ahead of class. Of course it is also designed to be a useful resource for pro-
fessionals working in financial markets, who will be able to utilise the book to link the
practice to theory.
The main features of the book are:

Key terms
The specialised financial terms used in each article are clarified. The style of this explanation
of terms is different to the standard approach of academic textbooks since practical analo-
gies are drawn to help students from a variety of backgrounds understand the concepts.
An insider’s view and self-review questions

Through a combination of practical and academic skills the author aims to bring these
Financial Times articles to life in a user-friendly way. Linked to each article is a selection of
xiv
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Preface
self-review questions, which the reader can use independently to test their understanding,
or they can form the basis for further discussion activities in class.
Linking this textbook to corporate finance textbooks

This book is designed to be used alongside a number of standard corporate finance text-
books. I have provided, therefore, a short guide to each topic at the start of every chapter
and links to the main books that are generally used on corporate finance courses at the
end of each chapter.
Research
At the end of each case I have included a section that offers the reader some useful sug-
gestions for further reading. These references always include the relevant chapter and
sometimes even particular pages from the chosen texts. Where relevant I have also
suggested the topics that are best covered in this particular book.
Data exercises and web-based activities

In most cases a data exercise is also integrated which requires the reader to obtain and
analyse specified data from the Financial Times that relate to the relevant topic. Where
appropriate, students are directed to a web-based activity, which will require them to
apply their newly acquired knowledge and to undertake further research or reading.
xv
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Online web content
This book is supported by a dynamic website at www.pearsoned.co.uk/boakes, which con-

tains links to useful financial websites and additional topical content. It is my intention to update
some of the issues discussed in this book as well as looking at some new stories as they emerge.
And finally some Podcasts

Finally, there will be a number of support podcasts with analysis of the key issues for a
selection of the articles. This will be an alternative method for the reader to understand
the analysis of the Financial Times articles.
This multi-strand approach within the one textbook recognises that students today are
familiar with, and indeed prefer, learning through a variety of media. They no longer want
to be restricted to the written word and benefit from the consolidation of material through
podcasts and web resources.
xvi
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The podcasts
If you go the website that supports this book you will be able to download 30 podcasts in MP3
format. Each one provides a short audio summary of the main issues relating to each article.
I recommend that you start by reading the FT article and my analysis. Then you should
listen to the podcast to hear the key points being re-enforced. It is a good way to revise
the key points in each topic.
The following podcasts are available to download at the book’s website (you can also
access them on iTunes):
I 1: Poor communications puts Sports Direct off track
I 2: Activist shareholders expect change at LogicaCMG
I 3: Sir Stelios spells out fears for easyJet
I 4: Bernanke to give a taste of more transparent Fed
I 5: How long can the good times last?
I 6: JPMorgan acts to reduce risk
I 7: Bank to give better guidance over rates
I 8: Surprising US job creation data rally stock markets and dollar
I 9: Bond yields spark credit concerns
I 10: Athens prepares 50-year bond issue worth €500–1bn
I 11: Convertibles stage a return to fashion
I 12: Record samurai deal by Citigroup
I 13: Flight to liquidity pushes eurozone bond yields apart
I 14: MyTravel shareholders offered 4% in £800 debt-to-equity restructuring
I 15: Blacks Leisure falls into the red
I 16: UK Investors dig in over pre-emption rights
I 17: IPO values Hargreaves at £750m
I 18: Valuing Sainsbury’s
I 19: Woolies investor opposes sale
I 20: Stock splits: time to query decades of dogma
I 21: Boots provides takeover acid test
I 22: 3i chief quits following steep fall in shares
I 23: Shareholders taking a stand on handouts
I 24: De La Rue pays special dividend
I 25: Discussions unlikely to yield white knight
I 26: Poison pill’s strength under analysis
I 27: Exporters curse dollar’s drag on profits
I 28: Facing down the threat of tighter rules
I 29: The demise of Northern Rock
I 30: The rescue of Citigroup
xvii
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A message to readers . . .
I really hope that you will enjoy your corporate finance course whether you are undergrad-
uates, postgraduates, just undertaking a short course or have already started your career
in the financial services industry. It is a very dynamic subject and, unlike many other
courses at University, your studies can so easily be related to real-life events. The Financial
Times is a great place to start to learn more about corporate finance in practice. You might
find it difficult to read at first but it does get easier as you learn more about the subject. I
hope this book will give you some guidance on how best to analyse relevant articles. Once
you have done a few of the cases here, try to do your own. Look for an article on a subject
that you have studied and then try to write a short review of the key points.
In addition, you should read the business sections of other newspapers, listen to the
radio and watch relevant TV programmes. The BBC broadcasts an excellent early morning
business programme on Radio 5, called Wake up to money. It looks at all the current finance
stories with expert guidance from some of the top names in the city. There is no need to
get up too early as you can download a podcast from the BBC’s website. This is an invalu-
able resource.
I hope you like the new edition of this book and I would like to wish you all the best
with your studies and your future career.
Best regards
Kevin
k.boakes@kingston.ac.uk
xviii
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A message to teachers . . .
An attractive feature of this subject is that it is so easy to relate the academic theory to
current practice. As a starter activity I begin each lecture by spending a few minutes
analysing an article that fits in with the topic that we are doing that week. The students
seem to really enjoy this aspect of the course and it creates a positive working atmosphere
for the rest of the session. In seminars I also try to combine some theory work with more
practical exercises. Finally, in the examination paper I include extracts from Financial Times
articles which require the students to provide relevant analysis. There is no doubt that the
students find this challenging but it is a clear signal that it is a key skill which they need to
acquire.
I hope you will enjoy the latest edition of the book and that you will be able to use it
as part of your teaching programmes. I have added several new articles to update some
of the key topics. I am sure that there are many other topics that you would have liked to
see included in this edition. This is inevitable as the aim was still to keep the book fairly
short, therefore I could not cover every available subject. If you see a good article that you
think would be appropriate for a further edition, perhaps you could send it to me?
If you have any comments, ideas or suggestions please e-mail me at:
k.boakes@kingston.ac.uk
Thanks so much for using the book and I hope you continue to enjoy teaching cor-
porate finance.
Best regards
Kevin
xix
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Acknowledgements
Many thanks to Andrea Dunhill, the Head of Accounting and Finance at Kingston
University, for giving me her full support with this project. I would also like to thank my
good friend and colleague, Brian Tan, for his assistance with the new edition.
I would also like to record my thanks to the many staff at Pearson Education who have
worked on this second edition. It was a pleasure to work again with the book’s editor, Ellen
Morgan. She is always so approachable and enthusiastic and as a result made the whole
writing process so straightforward.
To my wife Sue thanks for giving me her love and support. You are so amazing and so
beautiful. And finally thanks to my daughters Katy and Rachel who have developed into
wonderful young women in the blink of an eye. I am so very proud of what you have
achieved so far and I look forward to seeing your many future successes.
xx
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Publisher’s acknowledgements
We are grateful to the Financial Times Limited for permission to reprint the following
material:
Page 5: Sports Direct warning stumps investors, Financial Times, 27 April 2007 (Killgren, L.
and Blackwell, D.); 9: Logica’s chief quits in wake of warning, Financial Times, 28 May 2007
(Blitz, R.); 10: Investors expecting change at LogicaCMG, Financial Times, 30 May 2007
(Palmer, M.); 15: Sir Stelios spells out fears for EasyJet, Financial Times, 24 November 2008
(Done, K.); 24: Bernanke to give a taste of more transparent Fed, Financial Times, 14
February 2006 (Balls, A.); 32: How long can the good times last? Bankers cautious despite
bids and bumper bonuses, Financial Times, 27 November 2006 (Thal Larsen, P.); 36:
JPMorgan to cut prop trading desk, Financial Times, 4 November 2008 (Guerrera, F., Baer,
J. and Grant, J.); 40: Bank to give better guidance over rates, Financial Times, 3 May 2007
(Giles, C. and Daneshkhu, S.); 49: Surprising US job creation data rally stock markets and
dollar, Financial Times, 2 June 2007 (FT Reporters); 54: Bond yields spark credit concerns,
Financial Times, 8 June 2007 (Mackenzie, M., Beales, R. and Chung, J.); 55: Bond market
sell-off, Financial Times, 8 June 2007 (Lex Column); 64: Athens prepares 50-year bond issue
worth €500–€1bn, Financial Times, 18 January 2007 (Hope, K.); 70: Convertibles stage a
return to fashion, Financial Times, 8 February 2007 (Turner, D.); 75: Record samurai deal
by Citigroup, Financial Times, 6 September 2005 (Sanchanta, M.); 79: Flight to liquidity
pushes eurozone bond yields apart, Financial Times, 27 February 2008 (Chung, J.); 90:
MyTravel Shareholders offered 4% in £800m debt-to-equity restructuring, Financial Times,
14 October 2004 (Garrahan, M.); 94: Blacks Leisure falls into the red, Financial Times, 4
May 2007 (Braithwaite, T. and Urry, M.); 98: UK investors dig in over pre-emption rights,
Financial Times, 22 October 2007 (Burgess, K.); 109: IPO values Hargreaves at £750m,
Financial Times, 12 May 2007 (Spikes, S. and Saigol, L.); 110: Hargreaves Lansdown soars
on debut, Financial Times, 16 May 2007 (Spikes, S.); 114: Valuing Sainsbury’s, Financial
Times, 17 May 2007 (Lex column); 118: Woolies investor opposes sale, Financial Times, 20
November 2008 (Braithwaite, T.); 126: Stock splits: time to query decades of dogma,
Financial Times, 8 April 2007 (Authers, J.); 134: Boots provides takeover acid test, Financial
Times, 21 April 2007 (Hughes, C., Braithwaite, T. and Taylor, A.); 141: 3i chief Yea quits fol-
lowing steep fall in shares, Financial Times, 29 January 2009 (Arnold, M.); 150:
Shareholders taking a stand on handouts, Financial Times, 19 May 2007 (Hughes, C.); 155:
De La Rue pays a special dividend, Financial Times, 23 May 2007 (Griggs, T.); 162:
Discussions unlikely to yield white knight, Financial Times, 2 February 06 (Sanchanta, M.);
163: Mittal goes on Arcelor charm offensive, Financial Times, 31 January 2006 (Hollinger,
P.); 167: Poison Pill’s strength under analysis, Financial Times, 15 June 2007 (Nakamoto,
xxi
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Publisher’s acknowledgements
M.); 177: Exporters curse dollar’s drag on profits, Financial Times, 14 May 2007 (Hughes,
C.); 184: Facing down the threat of tighter rules, Financial Times, 20 June 2007
(Mackintosh, J.); 194: Fresh turmoil in equity markets, Financial Times, 11 August 2007
(Guha, K., Mackenzie, M. and Tett, G.); 196: Repo market little known but crucial to the
system, Financial Times, 11 August 2007 (Mackenzie, M.); 197: Growing sense of crisis
over interbank deals, Financial Times, 5 September 2007 (Tett, G.); 200: Bank throws
Northern Rock funding lifeline, Financial Times, 14 September 2007 (Thal Larsen, P. and
Hume, N.); 203: Brown saw no other option, Financial Times, 18 February 2008 (Parker, G.
and Thal Larsen, P.); 205: US government agrees to take biggest stake in Citigroup,
Financial Times, 28 February 2009 (Guerrera, F. and Beatte, A.).
We are grateful to the Financial Times Limited for permission to reprint the following
figures:
Page 11: From Investors expecting change at LogicaCMG, Financial Times, 30 May 2007
(Palmer, M.); 34: From How long can the good times last? Bankers cautious despite bids
and bumper bonuses, Financial Times, 27 November 2006 (Thal Larsen, P.); 71: From
Convertibles stage a return to fashion, Financial Times, 8 February 2007 (Turner, D.); 135:
From Boots provides takeover acid test, Financial Times, 21 April 2007 (Hughes, C.,
Braithwaite, T. and Taylor, A.); 151: From Shareholders taking a stand on handouts,
Financial Times, 19 May 2007 (Hughes, C.).
In some instances we have been unable to trace the owners of copyright material, and we
would appreciate any information that would enable us to do so.
xxii
M01_BOAK1818_02_SE_C01.QXP:M00_BOAK1818_02_SE_C00 3/11/09 08:17 Page 1
Topic 1
Introduction to corporate finance
The Companies and Markets section of the Financial Times is a fantastic source of
information about the trading performance of individual companies and their interaction
with financial markets right across the world. If you want to learn about finance you
need to be reading and understanding this part of the paper. You will find that the first
few pages are devoted to companies, then the emphasis shifts increasingly to financial
markets. A particularly strong section is the one titled ‘Markets and Investing’ which is
just inside the back page. It is here that you will find clear explanations of all the new
and innovative financial products that the banks have been busy developing. If you had
been reading this section in 2005 and 2006 you would have seen discussion of financial
market instruments such as structured investment vehicles, collaterised debt obligations
and mortgage-backed securities. Shortly afterwards they became an integral part of the
credit crisis that started in 2007 and soon swept through financial markets with great
dramatic force.
Before we can get into the minutiae of corporate finance we should start by examining
the role of finance both from within individual companies and from the perspective of
the economy as a whole. For all companies the finance function is the link between
them and the world’s financial markets. It enables them to undertake new capital-raising
initiatives both in the form of extra equity finance (this is in the form of new shares) or
extra bond finance (this is borrowed money).
In corporate finance it is usual to start by examining the role of the financial manager
within a company. Thie financial manager is the most senior individual manager
involved in the finance function. He/she will normally be a director with a seat on the
company’s main board. We can split their main activities into four main areas:
1. They will be in charge of the company’s financial planning process. This will
involve the preparation of a clear financial plan to set out just how the business is
expected to perform in coming years. The actual performance of the company can
then be compared against what was expected.
2. They will decide what the company should invest in. Most companies will con-
stantly be assessing new and competing investment proposals. For an energy
company it might be the decision to invest in a new nuclear or a coal-fired reactor.
The finance director will have a leading role in this decision making.
3. They will set out how the company should be financed. This will include how
much money the business needs overall and what is the best mix of capital that they
should be targeting. This will dictate whether they look to issue more equity finance
or simply increase the company’s borrowings.
4. And lastly they will be the company’s financial controllers. The financial managers
will play a key role in taking control of new investment and financing decisions. One
key aspect will be managing the company’s costs and expenses compared to their
income. This is important because it will have a significant impact on the perform-
ance and risk of the business.
When you start reading the Financial Times you will soon be able to pick new stories that
show the role of financial managers in practice.
For example, here are three FT headlines from the Companies and Markets section taken
from 15 September 2008:
‘Colonial agrees euro5bn debt restructuring’ – This is a good example of the financing
of a business.
‘Continental’s profit margin squeezed’ – This is a good example of the financial plan-
ning process in practice.
‘Aruze to open its first casino’ – This is a good example of a company capital invest-
ment decision.
Why not get hold of the FT today and do the same thing. Find some good examples of
global financial managers in action. In addition if you go to the book’s website you will
find some current FT stories discussed in my latest blog. Join in with your own
comments on the website.
Another common topic featured in the Companies and Markets section will be the
relationship between a company’s senior managers and its shareholders. One very
important issue that faces all companies is defining exactly what their corporate
objectives should be. This is essential to ensure that the company can decide on the best
courses of action. In corporate finance it is important to understand that in a modern
business there is normally a clear divide between the owners of the company (the
shareholders) and the day-to-day managers (the Board of Directors). This means that it
is often quite difficult for the managers to obtain a definitive idea of what the owners
want the business to achieve. In corporate finance we normally assume that the primary
focus of the company is in ensuring that the owners (the shareholders) are kept happy.
So, while there are a number of other stakeholders (employees, suppliers, local residents,
etc.) the interests of the company’s shareholders are seen as the main concern of the
company’s senior managers. Most managers work on the principle that keeping the
shareholders happy will guarantee that they will stay employed and also be very well
rewarded. If they disappoint them they know that their time will soon be up.
So we assume that the goal of a company is the maximisation of shareholder value. In

practice this is often simplified to be the maximisation of the company’s share price. We
are increasingly seeing larger shareholders becoming more active in making sure that
the company’s managers are acting in their interests. In reality it is true that certain
2
shareholders may not support the objective of wealth maximisation. For example, in
quoted Premier League football clubs the shareholders (and fans) may not want to see a
star player sold, even if this is a good financial decision. Sadly, in reality it seems to be
very difficult to apply the principles of good business practice to the running of football
clubs.
What other objectives might companies have? These might include:

1
INTRODUCTION TO CORPORATE FINANCE

Reducing the company’s borrowing levels In the MyTravel article (Topic 5) later in the
book we will see that for a company excessive debt often leads to greater risk of business
failure. So a company might have a target to reduce long-term borrowings to say 30 per
cent of total capital employed.
Retained profit levels It might be important for the company to be able to finance new
investments with its own internally generated profits. As a result a company might want
to ensure that the payments to shareholders (dividends) do not exceed a certain level of
distributable profits.
Getting a target market share There is little doubt that in practice many companies will
define one major corporate goal as being the achievement of a certain share of the market
in their particular sector. This might be because this gives them enhanced market power
enabling them to have a strong role in setting prices in this industry.
Corporate survival For some companies when the economy is in trouble their primary
focus might just be towards short-term survival. As an example, in the Autumn of 2008
we saw the bankruptcy of several airlines (including XL Leisure and Silverjet) hit by the
combination of rising costs (higher oil prices) and falling demand (due to the credit
crunch).
Profit maximisation If asked what the aim of a company should be many people might
reply maximising profits. It should be stated that profit maximisation does not equal share-
holder wealth maximisation. Maximising profits in the short term can sometimes be at the
cost of damaging the business in the long term. For example, a company might reduce
labour costs by sacking some key sales staff. This might raise short-term profits but as the
sales start to slide due to the reduced sales force the future prospects of the company
might well decline.
So we have seen that finance plays a key role for many companies. You should also
understand that the financial services industry is very important to the economy more
generally. The health of the national economy depends to a large extent on the financial
services sector. One only has to see the grave concerns of the leading national
governments worldwide during 2008 when the problems in the banking sector began
to threaten the world economy to a frightening extent. So like it or not there is no
doubt that we need to read and understand the financial news.
The following four articles are analysed in this section:
Article 1
Sports Direct warning stumps investors
3
Article 2
Logica’s chief quits in wake of warning
Article 3
Investors expecting change at LogicaCMG
Article 4
Sir Stelios spells out fears for easyJet
These articles address the following issues:

I the role of shareholders in companies;
I the impact of a profit warning on the share price;
I what differences there are for a listed company;
I the importance of maintaining good investor relations;
I activist shareholders and the way they can force change within companies;
I what is meant by good corporate governance including the role of a non-executive
chairman;
I conflicting corporate strategies;
I the importance of cash to a company;
I growth versus mature companies.
4
Poor communications puts Sports Direct

off track
When reading the financial press you can sometimes get the impression that getting rich
1

is easy. Investors should buy shares in any companies that are floating on the stock market
for the first time and then just sit back and wait to see their value soar. This article shows
that there is another side to the story. We look at a company called Sports Direct that
floated with an initial share price of 300 p back in late February 2007. Following the diffi-
culties highlighted in this article these shares closed on the 27 of April at just under 224 p.
This shows the risks associated with buying into new share issues and also the importance
of good investor relations for all companies. The City exacts a swift revenge on any
company that forgets the importance of effective communication with their shareholders.
Article 1 Financial Times, 27 April 2007 FT
Sports Direct warning stumps investors

Lucy Killgren and David Blackwell
Sports Direct, the sports retailer that ‘acutely conscious of the frustration that
made a controversial debut on the stock has been expressed by analysts and the
market earlier this year, has suffered press, and we are working to close that
another blow to its credibility after gap – but it will take some time’.
warning that sales growth had slowed. Philip Dorgan, retail analyst with
The group, run by publicity-shy billion- Panmure Gordon, said the statement had
aire Mike Ashley, expects profits to be ‘set the alarm bells ringing’ and implied a
broadly in line with latest expectations, dramatic slowdown in sales, given that in
although there have been several down- the last update sales were up by 22 per
grades over the past month. cent.
The group, owner of the Lillywhites He said the ‘total absence of numbers’
and Sports World stores and brands was leading him to downgrade estimates
including Dunlop and Lonsdale, also said: by 9 per cent for the current year to
‘Sales growth in the main UK retail busi- £141.4 m, and by 20 per cent for the fol-
ness is slower than earlier in the year, but lowing year.
remains positive’. Jonathan Pritchard of Oriel Securities
Analysts and investors, already puzzled said making forecasts on the retailer was
by the company’s decision to part akin to ‘pinning a tail on the donkey’ as
company with its public relations and the statement had ‘no numbers whatso-
investor relations advisers just after the ever’. Richard Ratner of Seymour Pierce
flotation, were angered by lack of access to stuck to his forecast of £143.5 m pre-tax
Bob Mellors, finance director. David profits. But he reminded investors that
Richardson, chairman, said the board was Mr Ashley was a bit of a maverick, and it
5
Article 1 Sports Direct warning stumps investors
did not help to have a ‘no-show’ finance has now fallen more than 25 per cent
director. since listing in early March compared
The shares, listed at 300 p less than two with a rise of 1.3 per cent for the broader
months ago, recovered some of their early market.
fall to close down 121⁄2 p at 223⁄4 p. The price
The analysis
Sports Direct the retailer was created by the billionaire entrepreneur Mike Ashley. He has
established an impressive business based on a number of iconic sporting brand names
including Lonsdale, Kangol, Slazenger, Lillywhites and Dunlop. This list takes me back to
the mid-1970s when I can remember saving my weekly pocket money to buy a highly
prized Dunlop Maxply tennis racquet. Armed with this new weapon, I confidently
expected to take Wimbledon by storm. Sadly this was yet another sporting ambition that
was never to be realised!
Let’s get back to Sports Direct. At the end of February 2007 Mr Ashley floated his busi-
ness on the London stock exchange with a share price of 300 p. He took advantage of the
flotation to sell a large stake in the business giving him a cash bonanza of some £900 m.
This no doubt provided the finance for his subsequent takeover of Newcastle United foot-
ball club. Sadly, since the time of the stock market flotation, Sports Direct has been hit by
a number of problems which have resulted in a severe slide in the share price.
A common factor in the company’s difficulties was that it had been associated with very
poor investor relations. At the time of the share issue, Mr Ashley admitted that it should
have appointed a new investor relations firm well before the flotation. Since then the
company has tried to improve its corporate governance and repair its damaged reputation
with the City.
In this article we see that in its latest announcement ‘the company was warning that its
sales growth had slowed’. It is not clear whether this is a formal ‘profits warning’ or just a
negative trading update. This results in a leading retail analyst at Panmure Gordon con-
cluding that this statement had ‘set the alarm bells ringing’ as this evidence of a slowdown
followed a previous announcement that sales were up by 22 per cent. As a result he made
sharp profit downgrades for both 2007 and 2008.
The City likes good news about a company’s prospects. It can even learn to live with
some bad news if it is fully explained and there is still a well-founded confidence that
things will improve. However, the one thing that the City always takes a dim view of is
when a company offers a confused picture in relation to its financial performance. There
are a host of highly skilled retail analysts employed by the large investment banks, and
these demand good and effective communication between the company and their
investors. Investors will sell the shares of any company that produces poor, confused and
apparently contradictory trading statements.
On the same day as this article in the Financial Times, the excellent Lombard column
argued that the company should not be delisted, for rather unusual reasons. The comment
was: ‘simply as a case study of how not to handle one’s first months on the public markets,
6
Sports Direct has already proved to be a huge asset to the Stock Exchange’. Some might
regard this as a harsh but maybe perfectly fair judgement on Sports Direct’s performance.
The episode underlines the importance of a company maintaining good communications
with their shareholders and the financial press.
I Key terms
1

Profits warning Companies are required to keep shareholders well informed about the per-
formance of the company. As a result, if a company knows that its future profits will be
significantly less than the stock market currently believes, it is required to warn the market. The
result of such a warning is normally a sharp fall in the share price.
Corporate governance This is a general term used to describe the relationship between the
owners of a business (the shareholders) and the managers of the business. It covers the various
mechanisms by which the shareholders can try to make sure that the managers act in their
interest. This should ensure that the managers are open, fair and fully accountable for all their
actions.
Investor relations A key aspect of good corporate governance is the requirement that the
senior managers of a company are expected to keep up a constant dialogue with the share-
holders. This includes the necessity to make sure they are in touch with their opinions on a
range of important issues. This should be done through such things as the annual general
meeting, the sending of regular news updates and the provision of a company website. Most
of these websites now include a section covering investor relations.
Delisting This is simply when a company is removed from a stock exchange. This might be
done by a company that decides that it has simply become too onerous to meet all the rules
and regulations set out by the stock exchange. Such companies are not necessarily bankrupt
and it is quite possible that the shares will still trade in the over-the-counter market where
buyers and sellers will be brought together.
I What do you think?

1. Why is it so important for a company to maintain effective communications with its
shareholders and the City in general?
2. What steps might Sports Direct take to improve its investor relations?
3. The sharp fall in Sports Direct’s share price suggests that it is behaving in a way that is
consistent with a semi-strongly efficient stock market. What is the evidence to support
this view?
Hint: A good source for this topic is Arnold, G. (2007) Essentials of Corporate Financial
Management, Harlow, UK: FT Prentice Hall. You should look at p. 229 to see a concise defi-
nition of the three levels of efficiency.
7
I Go to the web
Go to the website for the Financial Times at www.FT.com.
Now go to the Quotes field at the top right and enter: UK:SPD.
a. What is the current share price for Sports Direct?
b. Look at the 52-week high and low share prices.
Using this data discuss the volatility of Sports Direct’s share price in the last year.
I Research
Arnold, G. (2007) Essentials of Corporate Financial Management, Harlow, UK: FT Prentice Hall.
You should look at pp. 195–6 to learn more about listed companies.
Arnold, G. (2008) Corporate Financial Management, 4th edn, Harlow, UK: FT Prentice Hall. You
should especially look at Chapter 1, pp. 15–18 to get more information about corporate gov-
ernance.
Berk, J. and DeMarzo, P. (2009) Corporate Finance, Harlow, UK: FT Prentice Hall Financial Times.
The topic of corporations is covered in Chapter 1. The corporate management team is intro-
duced on p. 10.
Gitman, L. (2009) Principles of Managerial Finance, 12th edn, Pearson International Edition.
There is a US-based introduction to the link between finance and business on pp. 4–21.
McLaney, E. (2009) Business Finance Theory and Practice, Harlow, UK: FT Prentice Hall Financial
Times. You will find an introduction to the role of business finance on pp. 4–12.
Pike, R. and Neale, B. (2006) Corporate Finance and Investment, 6th edn, Harlow, UK: FT Prentice
Hall. You should look at Chapter 1, especially pp. 5–7 to see a discussion of the role of the
financial manager.
Watson, D. and Head, A. (2007) Corporate Finance Principles and Practice, 4th edn. Harlow, UK:
FT Prentice Hall. You should look at Chapter 1. In addition the process of listing is explained on
p. 96.
8
Activist shareholders demand change at

Logica
Shareholders are the key providers of long-term finance to companies. As long as a

1

company performs well and provides them with excellent financial returns they will leave
the company to manage its business. However, if a company runs into trouble and the
share price slides, the company can expect some immediate agitation, especially from its
largest shareholders.
The relationship between a company and its shareholders is clear. The shareholders give
up their hard-earned money to the managers of a business in the expectation that they
will make good use of the funds. They will hope to see substantial returns in the form of
a rising share price as well as a stream of dividends. The other long-term capital comes
from the providers of debt capital. Their relationship with the company is quite different.
Unless there is serious default they lend money to the company in the certain expectation
of its return in the form of interest and the eventual return of the principal. The debt
holders must accept lower returns reflecting the lower risk. In contrast, the shareholders
expect much higher returns to compensate for the greater risks that they take.
These articles show what happens when key shareholders become unhappy with the
performance of a company. The role of activist shareholders is to make it clear to managers
of a business that they want to see substantial change. In this case they are demanding
changes at LogicaCMG. This was to start with a new chief executive who was expected to
be appointed from outside the business.
Article 2 Financial Times, 28 May 2007 FT
Logica’s chief quits in wake of warning

Roger Blitz
Britain’s fiercely competitive IT services margins at its UK business would be

market yesterday claimed the scalp of lower than last year, and full-year rev-
Martin Read, chief executive of LogicaCMG, enues would be below those of 2006. The
who declared he was stepping down as a profit warning has knocked 9 per cent off
direct consequence of last week’s profits the company’s share price.
warning from the Anglo-Dutch group. Mr Read said the reasons for the
Logica announced that it would look decline, a downturn in UK trading and a
both inside and outside the company for a £10 m–£15 m over-run on one project,
replacement. Mr Read, who has run the were neither ‘huge’ nor ‘strategic’ prob-
company for the past 14 years, will stay on lems.
until a successor is identified. But a statement from Logica’s board
His departure came after Logica last yesterday said that ‘in the light of the
week warned that first-half revenues and unsettling speculation following the
9
Article 3 Investors expecting change at LogicaCMG
company’s recent trading update, Martin Logica, which bought French rival
Read has decided to accelerate his retire- Unilog in 2005 for £631 m and WM Data
ment plans’. of Sweden for £876 m last year, is com-
The company also said that its 14- peting with rivals such as Wipro, TCS and
strong board, which is seeking more Infosys – all Indian companies – in the
non-executive directors, would reconsider UK. The market, which has historically
its size and structure. been viewed as the company’s best-
It is understood that, following the managed operation, generated 25 per cent
profit warning, several leading share- of the company’s £2.7 bn in revenues last
holders told board members that it was year.
time for the company to look at succes- Logica’s first quarter UK revenue was
sion. down 4.1 per cent at £174.6 m and second
Mr Read, who is 57, is thought to have quarter revenues are likely to be lower
previously broached the subject of his than the first. First-half underlying
retirement with several board members, margin in the UK was expected to be
and decided that, with shareholders about 3 per cent lower.
voicing their disquiet, he should accel- The company was responding to the UK
erate his departure. competition by accelerating the move of
Cor Stutterheim, chairman of Logica, some staff to lower-cost offshore locations
said that he accepted Mr Read’s decision at a cost of £2 m and job losses.
with regret, noting that he had built a UK It has seen growth slow in the past year
business of 3000 staff into an inter- when it struggled to recruit enough IT
national operation of 40 000 employees in consultants in France. Mr Read was plan-
41 countries. The company was formed ning to focus on consolidation.
after the merger of UK-based Logica with
CMG, the Dutch group, in 2002.
Logica is the seventh largest IT services
company in Europe by revenues, and 19th
in the world.
Investors expecting change at LogicaCMG

Maija Palmer
Investors expect sweeping changes at operating officer of the Anglo-Dutch IT

LogicaCMG following the departure of services group, are obvious internal candi-
Martin Read as chief executive – though dates.
there is little clarity as to who will succeed But both are long-time LogicaCMG
him. executives and closely associated with Mr
A successor to Mr Read is widely Read, who has had a difficult relationship
expected to come from outside the with the City.
company although Seamus Keating, chief Mr Read announced plans to step
financial officer, and Jim McKenna, chief down from LogicaCMG this week in
10
response to intense pressure from Gerard Philippot, non-executive director

activist shareholders such as Morley and former president of Unilog, the
Fund Management, who were disap- French business LogicaCMG acquired in
pointed by the company’s profits warning 2005.
last week. Investors have questioned the inde-
The warning of poor performance at pendence of Cor Stutterheim, the 1
LogicaCMG’s UK operations was the last non-executive chairman and former

straw for many investors, following the chairman of CMG, which merged with
controversial acquisition of Sweden’s Logica to form the group in 2002. His
WM-Data last year and a warning of poor close ties with the group mean he is not
performance at its French business in considered independent under the com-
January. bined code on corporate governance.
‘It is almost a dead certainty that the LogicaCMG yesterday said Mr
new CEO will be someone brought in Stutterheim did not plan to step down in
externally’, said Kevin Ashton, analyst at the immediate future. But many believe
Bridgewell. ‘The company has managed to he may go shortly after the new CEO is
keep all the executives in place for a long installed.
time, and it’s quite a “cosy” board . . . If LogicaCGM
you are an activist investor, those guys are Total return indices (rebased since merger)
all tarred with the same brush’.
Another analyst, who declined to be 200
named, said: ‘The perception has been

that management – not just Martin Read Software and
Computer Services
– have been underperforming, and so they Sector
are likely to veer towards looking outside’. 150
The head of European operations for a
large US-based IT company would make
an ideal candidate for the top job, analysts
said. 100
LogicaCMG plans to examine the
‘appropriateness’ of the board’s size and
structure, suggesting it will be slimmed
LogicaCGM
down from the current 14 members.
50
It has faced questions about a
consulting contract worth €300 000 2002 03 04 05 06 07
(£203 732) a year the company had given Source: Thomson Datastream
I The analysis
LogicaCMG is a leading information technology outsourcing and services group which
employs some 41 000 people worldwide. The chief executive officer (CEO), Martin Read,
spent some 14 years establishing the business in this sector. During May 2007 the
company announced a profits warning with the news that first half revenues and margins
at its UK’s business would be lower than the previous year and full year revenues would be
below those of 2006. This announcement had the immediate impact of wiping 9 per cent
off the company’s share price. The first article reports that the reasons for the decline
include a sharp deterioration in its trading performance in the UK and a large overspend
11
on an individual project. In response to this announcement, the CEO decided to bring

forward his retirement plans. The second article reports that his successor was widely
expected to come from outside the company despite two possible internal candidates.
One of the key activist shareholders, Morley Fund Management, was clearly expressing
a strong desire for change. An analyst at Bridgewell Securities is quoted as saying that ‘the
company has managed to keep all the executives in place for a long time, and it’s quite a
“cosy” board . . . If you are an activist investor, those guys are all tarred with the same
brush’. As a result, the activist shareholders will want to see someone new who can come
in and shake up the business.
Some key aspects of the way that the business was being run were being called into
question. This includes the need to reduce the board of directors down from 14. The
Financial Times also reports that there were concerns about the consultancy position
enjoyed by Gerard Philippot, a non-executive director and former president of a
French business that LogicaCMG acquired in 2005. Finally there were doubts about
the level of independence of Cor Stutterheim the non executive chairman and former
chairman of CMG which merged with Logica to form the combined group in 2005.
His association with the group undermined his independence ‘under the combined
code on corporate governance’. He was expected to leave after a new CEO was in
place.
I Key terms
Long-term finance In most companies this is the key finance that underpins its business activi-
ties. It is made up of a combination of equity finance (provided by the shareholders) and debt
finance normally issued in the form of new bond issues. This long-term finance will allow the
company to make new investments and it could also fund mergers and acquisitions.
See Article 16 for more discussion of long-term finance. You should look at the capital struc-
ture section in the ‘Key terms’ section.
Shareholders (activist) In most companies the shareholders provide the bulk of the long-term
finance. This makes them the key stakeholders in the business. They are the owners of the busi-
ness and the managers must always remember that they are merely acting as agents working
on behalf of the shareholders who are the principals. We normally assume that the primary
objective of a company is to maximise the wealth of its shareholders. In practice this is simpli-
fied to maximising the company’s share price.
The shareholders range from private investors with small stakes in the business right up to
the large financial institutions that often own a significant percentage of the equity of a busi-
ness. It is normally among these larger shareholders that we find the activist shareholders. These
are the shareholders who believe that the managers are not doing a good job and as a result
they will attempt to alter company policy and even possibly seek to replace existing senior man-
agers with new people who they think will do a better job.
Chief executive officer (CEO) This is the top person in the company who will have the main
responsibility for implementing the policies of the board of directors on a daily basis. Put simply,
they are running the business.
12
Non-executive chairman This is supposed to be a person who is independent of the core man-
agement team. They will normally be employed on a part-time basis and will chair the main
board of directors. In addition the CEO can look to them for advice and guidance. You will also
see the term NED, which stands for non-executive director. Most public companies will employ
a number of part-time NEDs to give independent advice on the running of the company’s oper-
ations. 1
Default This is where a borrower takes out a loan but fails to keep to the original agreed schedule

of interest payments and final capital repayments. See Article 7 on p. 36 for a full definition.

1. Discuss how company shareholders can encourage their managers to act in a way
which is consistent with the objective of shareholder wealth maximisation.
2. In what situations might we expect there to be a significant increase in the number of
activist shareholders in a company?
Hint: Think about the performance of the company’s share price.
3. Using the Logica articles above, discuss the role of a non-executive chairman in a
company.
I Investigate FT data
You will need the Companies and Markets section of the Financial Times. In addition, go
to the website for Tesco plc at www.tescoplc.com.
Go to the section entitled ‘Investor Centre’.
1. Find the current share price for Tesco plc.
2. Look at the London share price service in the Financial Times and find the high/low for
this share in the last 52 weeks. How does the current share price compare to this
high/low?
3. Go back to the Tesco website (Investor Centre section).
Identify the main shareholders in Tesco plc.
4. You are now required to prepare a PowerPoint presentation:
Go to the latest summary and annual review.
Now find the chief executive’s statement. Using this information, you are required to
prepare six PowerPoint slides.
Slide 1: provide a short profile of the company (nature of business, market capitalisa-
tion, etc.).
Slide 2: what are the corporate goals (financial and non-financial)?
Slide 3: what does the company say about total shareholder return and/or dividend
policy?
Slide 4: discuss some current FT stories about this company.
13
Slides 5–6: review the company’s financial management – look at any new issues of
bonds and shares and the role of its treasury department, including any risk-manage-
ment activities.
I Research
You should look at pp. 28–29 for a very clear discussion of the problems of corporate gover-
nance in practice.
Arnold, G. (2008) Corporate Financial Management, 4th edn. Harlow, UK: FT Prentice Hall
Financial Times. You should especially look at Chapter 1. The topic of corporate governance is
well explained on pp. 15–18.
Atrill, P. (2007) Financial Management for Decision Makers, 5th edn, Harlow, UK: FT Prentice Hall.
You should look at chapter 1, pp. 6–20 set out ‘why businesses exist’.
The topic of corporate governance is covered in Chapter 29.
Gitman, L. (2009) Principles of Managerial Finance, 12th edn, Harlow, UK: Pearson International
Edition. There is a US-based introduction to corporate governance on pp. 16–17.
McLaney, E. (2009) Business Finance Theory and Practice, 8th edn, Harlow, UK: FT Prentice Hall
Financial Times. You will find an introduction to corporate governance on pages 9–12.
Pike, R. and Neale, B. (2006) Corporate Finance and Investment, 6th edn. Harlow, UK: FT Prentice
Hall. You will find a discussion of the problems of corporate governance on pp. 14–16.
Watson, D. and Head, A. (2007) Corporate Finance Principles and Practice, 4th edn, Harlow, UK:
FT Prentice Hall. You should look at pp. 18–21 for an introduction to the topic of corporate gov-
ernance.
14
Not so easy for Sir Stelios!

The corporate profile of easyJet and its flamboyant founder, Sir Stelios Haji-Ioannou, was
much enhanced by the ‘fly on the wall’ documentary series Airline which was first shown
on the ITV network in 1999. It went on to become one of the defining docusoaps that 1
came to dominate our screens in the new millennium. Many of the weekly episodes of

Airline focused on the interaction between easyJet’s staff and their eclectic mix of
passengers during some pivotal moments in their lives. These included weddings, births,
crucial international football matches as well as the more mundane holidays. The highlight
of many episodes was the inevitable tears that resulted from passengers missing their flight
check-in times by a few minutes. Such tension made perfect watching for the millions of
viewers.
At the time of this article the world’s airlines were facing up to the realities of the impact
of a worldwide recession on their businesses. These issues were brought into sharp focus
in late 2008 when Sir Stelios fought a bitter battle with the rest of the senior management
team at easyJet. He wanted the company to restrict its growth plans and instead focus on
generating cash which would be needed to fund the acquisition of new A320 short-haul
aircraft over the next four years.
Article 4 Financial Times, 24 November 2008 FT
Sir Stelios spells out fears for easyJet

Kevin Done
Sir Stelios Haji-Ioannou, the founder and with a total value of $5.1 bn (£3.4 bn) at
largest shareholder in easyJet, dug in his list prices before heavy discounts.
heels on Sunday in his public disagree- ‘I am keen to focus the debate on how
ment with the rest of the airline’s board much they cost, and how they are to be
over its growth strategy in the midst of paid for, rather than on passenger num-
the deepening recession. bers’, he said.
In an interview with the Financial Sir Stelios, who founded easyJet in
Times, he said he was engaging with other 1995, has been a pioneer, alongside
shareholders and with financial analysts Ireland’s Ryanair, of the low-cost business
to explain his concern that the group was model in Europe. It has been built on cap-
not sufficiently focused on conserving turing large chunks of market share from
cash and on limiting its big capital expen- established carriers as well as on stimu-
diture commitments. The group’s leading lating growth by offering much lower
institutional investors include Standard fares and by having a lower cost base than
Life, Wellington, Fidelity and Schroders. other airlines.
‘The real issue is the Airbus contract’, The rapidly expanding low-cost carriers
he said, under which easyJet is committed have been given a valuation premium as
to taking delivery of 109 new A320 family growth stocks, but Sir Stelios said he
short-haul jets during the next four years believed this era was over. ‘At the heart
15
Article 4 Sir Stelios spells out fears for easyJet
the question is are we a growth company Yesterday Sir Stelios expressed the
or a mature company. I think it [easyJet] concern that low-cost airlines were not
is a mature company.’ recession-proof like low-cost food stores
EasyJet’s management, backed by the such as Wal-Mart, Aldi or Lidl.
rest of the board, said last week it was He feared the customers would not be
taking a cautious approach, but Sir there to fill all the ‘aluminium tubes’ on
Stelios, a non-executive director, told order from Airbus. ‘Anyone just unem-
investors he believed that the group’s ployed must still go to Aldi to buy the
approach was ‘based on optimistic cheapest food to survive’, he said, ‘but he
assumptions about future revenues’. does not need to go for a stag party to
EasyJet’s shares are down 5 per cent Prague with his mates.’
since the row emerged a week ago.
I The analysis
When companies perform well and their share prices behave in a robust manner it is quite
possible for their senior managers to remain in the background driving the business
forward and enjoying substantial personal financial rewards. However, when economic
activity slides and share prices go into reverse these same managers start to hit the head-
lines. This case is slightly unusual, as the person involved was Sir Stelios Haji-Ioannou who
is the founder and largest shareholder in easyJet. It would be hard to describe him as a shy
and retiring individual. On the contrary, whenever the media wanted a savvy business
person to comment on a news story, he would be high on the list, perhaps coming just
below Sir Alan Sugar or one of the members of the BBC’s Dragon’s Den.
This particular FT story related to a rather embarrassing public spat that developed at
the end of 2008 as Sir Stelios vented his displeasure at the corporate strategy being
employed by the other board members at easyJet. It was a particularly interesting article
as it must have mirrored a number of similar debates that were taking place in boardrooms
up and down the country at that time. The important question was just how a company
should be run against the background of a rapidly ailing economy where sales were
shrinking and sources of business finance were very scarce.
In the case of easyJet Sir Stelios was pushing the company to operate a far more cau-
tious strategy with a strong emphasis on the company holding on to as much cash as
possible and limiting any capital investment projects to the bare minimum required. He
was particularly concerned that the company should preserve as much cash as possible to
fund the new Airbus aircraft which easyJet was committed to purchase. Sir Stelios made a
direct appeal to the company’s main institutional investors, Standard Life, Wellington,
Fidelity and Schroder’s, to lend their support to his viewpoint. This was very different from
his previous more flamboyant approach which had seen the business enjoy rapid growth
with its low fares substantially boosting the market for air travel particularly in the
European market. He argued that by late 2008 easyJet should no longer consider itself to
be a growth company, but instead should position itself as a more mature business which
should operate a cautious strategy in this economic downturn. The FT article quotes him
as saying low-cost airlines were not recession-proof companies like low-cost food stores
16
such as Wal-Mart, Aldi and Lidl. While we all need to eat food no matter what, we do not
need to fly to Bilbao, Catania or Dortmund!
The other board members at easyJet would not have regarded themselves as being par-
ticularly rash or irresponsible in their running of the business. At this time they included
individuals like Sir Colin Chapman (former Chief Executive of Rolls-Royce), Sir David
Michels (Deputy Chairman of M&S) and Dawn Airey (from Channel Five). They would 1
surely be just as sensitive to the worrying decline in business confidence and just as likely

to have set the correct course for easyJet against this changed economic background.
Sir Stelios, a non-executive director, also challenged the company’s dividend policy.
Since its birth as a business easyJet had never paid any dividends to its shareholders.
Instead it sought to reward its shareholders through share price gains in the same way as
other similar high-growth companies. Some critics at the time wondered if Sir Stelios’s
desire to see the business rebranded as a mature company that paid dividends had some-
thing to do with his need to get some income from his own shareholding. With easyJet’s
share price falling so sharply during 2008 it could be seen as one way of protecting his
primary financial asset during a period of declining economic activity.
I Key terms
Growth strategy This refers to the strategy employed by a company aimed at increasing its market
share. It is possible that in the short term a company might set out to chase additional sales even at
the cost of reducing short-term earnings. The tactics used to increase market share might include
the development of new products or services and diversification into new international markets.
Capital expenditure This term is used to cover any money that is invested in a business to buy
new fixed assets like machinery, technology or industrial buildings. The aim of this expenditure
is to enable the company to increase production of goods or services and generate higher
income in future years. Economists see this type of investment as being vital in terms of securing
higher rates of economic growth in the future.
Valuation premium In corporate finance we use many different techniques to arrive at the
correct valuation for the shares in a company. These are normally based on important factors
like the company’s future dividends or earning streams. It is normally the case that we place a
higher value on companies that are expected to achieve significantly higher growth rates than
other companies in similar business sectors.
Growth/mature company It is important to be able to distinguish between a growth

company and a more mature one. A growth company is one that has a rate of growth that is
significantly higher than is the norm. They will generally be characterised by heavy investment
programmes and low dividend payments to their shareholders. In contrast, a mature company
has already done its growing and it has now reached the stage where future expansion plans
are limited by the size of their market. These companies will be characterised by much less
ambitious business investments but rather more generous dividend payments to shareholders.
Non-executive director (NED) You will often see the term NED, which stands for non-
executive director. Most public companies will employ a number of part-time NEDs to give
independent advice on the running of the company’s operations.
17

1. What were the main concerns of Sir Stelios Haji-Ioannou, the founder and largest
shareholder in easyJet, in terms of the airline’s future business strategy?
2. Why might it have been particularly important for easyJet to hoard cash at this time?
3. What is the difference between a growth company and a mature company? Discuss
the likely dividend policy of these different types of companies.
4. Why are the profits of airlines particularly susceptible to economic slowdowns?
Hint: Consider the likely impact on demand for air travel and their main costs like oil and
the nature of their capital expenditure on new aircraft.
You will need the Companies and Markets section of the Financial Times. Go to the London
Share Price Service. This is normally 2–3 pages inside from the back page of the
Companies and Markets section. You will find here lots of useful share price data for the
companies that have their shares quoted on the London Stock Market. You will see that
the companies are allocated to a range of different sectors ranging from Aerospace and
Defence to the Utilities. The shares shown in bold are the ones currently included in the
main UK stock market index, called the FTSE 100.
1. You are now required to identify five companies that could be regarded as being
‘mature companies’. Explain why each one matches this definition.
2. You are now required to identify five companies that could be regarded as being
‘growth companies’. Explain why each one matches this definition.
I Research
Chapter 1 sets out the objectives for a business.
Arnold, G. (2008) Corporate Financial Management, 4th edn, Harlow, UK: FT Prentice Hall
Financial Times. You should look especially at Chapter 1. On pp. 3–15 you will see a good dis-
cussion of the objectives of companies. In addition you will see a discussion of the dividend
policies of companies in Chapter 22.
There is a useful discussion on the subject of shareholder activism on pp. 19–23.
The topic of corporations is covered in Chapter 1. Ownership versus control of corporations is
on pp. 9–12.
Edition. There is a US-based introduction to the goal of a firm on pp. 13–21.
Financial Times. There is a discussion of the organisation of businesses on pp. 6–7.
18
Hall. You should look at Chapter 1. There is a good section on ‘Cash – the lifeblood of the
business’ on p. 7.
FT Prentice Hall. You should look at Chapter 1.
1
Go to www.pearsoned.co.uk/boakes to access Kevin’s blog for additional analysis

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taining short audio summaries of the main issues relating to each article and check
your understanding of in-text questions with the handy hints provided.
19
Topic 2
Financial institutions featuring
investment banks
In contrast to Companies and Markets, the main section of the Financial Times focuses
much more on economic issues, especially the way they impact on the most important
financial institutions. We can define a financial institution as an agent that provides a
range of important financial services for its various clients. Its primary purpose is to bring
together the economic players with spare money (the lenders) and those with a financial
deficit (the borrowers). Financial institutions facilitate the transfer of resources between
them. Let us look at a simple example.
A company may need to raise extra capital to finance a new investment opportunity. It
needs to raise £1bn, with half of it coming from extra share finance (equity) and the
other half from additional borrowing (debt). It might well go to a large investment bank
(for example Goldman Sachs) which will make this capital raising much easier. The
bank’s equity team will organise a new share issue allowing large pension funds to buy
shares in a new stock market issue. The bank’s debt team will launch a new bond issue
on behalf of the company. If these new issues are successful, the company will soon
have the finance that it requires to move ahead with the new investment project.
The investment bank is important because:

a. It will manage the return on the new issues. This means that it will help the two parties arrive
at a reasonable price for the new shares and a fair interest rate on the new debt securities.
b. It will manage the risk on the new investments. This means that it will organise the
new financial instruments in such a way as to ensure that both parties (the borrower
and the lender) do not end up with more risk than they can deal with.
c. It will combine amounts of capital from various lenders to ensure that the company
can borrow the full amount that it requires.
d. It will manage the liquidity on the new investment. It is possible that the company
will want to raise very long-term finance in order to fund the new investment oppor-
tunity. The lenders might be reluctant to make their finance available for such a long
period. The investment bank can structure the new financial market securities in such a
way that both sides get what they want. For example, with a new 20-year bond issue
the company gets long-term funding. At the same time the buyers of these bonds can
sell them long before their maturity if they need to cash in their investments.
The most common financial institutions include the retail banks, building societies,
investment banks and the central banks. We should start this section by setting out what
these all do.
Financial institutions featuring investment banks
1. Retail banks. These are the well-known high street banks like HSBC, NatWest and
Barclays. They take deposits from their retail clients and then lend this money out to
their individual and commercial customers. The banks also offer a range of other
services including foreign exchange facilities, investment advice and secure deposit
facilities.
2. Building societies. These days it is increasingly difficult to differentiate between the
role of banks and the role of building societies. In the past the main difference was
that building societies were mutual organisations owned by their members who held
savings accounts with them. In addition, the main role of a building society used to
be the provision of mortgages to enable people to buy their homes. In recent years
we have seen many building societies turn themselves into public companies
through share issues. Furthermore, building societies have now diversified the range
of their activities to include many new services.
3. Investment banks. Whenever a large company needs to raise finance, the first port
of call will be an investment bank. As classic examples of financial intermediaries,
these banks act as go-betweens to the issuers of capital (governments and
companies) and the investors in capital (pension funds and insurance companies).
Most investment banks are split into two main divisions. The first helps companies
with the issue of new equity market securities. The second offers companies the
chance to issue new bond market securities.
4. Central banks. Just about all countries now have a national central bank and it is
normally their most important financial institution. National banks have two primary
functions. The first is to oversee the workings of the financial system and to ensure
that all other financial institutions are operating securely. The second key role of the
central banks in most countries is to determine the correct stance of monetary policy.
In practice, this means that they set the level of short-term interest rates in the
economy. In so doing, they must achieve the economic goals that are set by the
national government. The central bank in the United States is called the Fed. The
central bank for the Eurozone is called the European Central Bank. Finally, in the UK
the central bank is called the Bank of England. It is not clear where this leaves
Scotland, Northern Ireland and Wales!
In this section you will see articles that examine the role of central banks, as their actions
have a major impact on the stock markets, the currency markets and the bond markets.
I have also included two articles on investment banks, which are at the centre of a
number of corporate finance activities, and I have tried to give an insider’s view of their
main functions.
Article 5
Bernanke to give a taste of more transparent Fed
22
Financial institutions featuring investment banks
Article 6
How long can the good times last? Bankers cautious despite bids and bumper
bonuses
Article 7
JP Morgan to cut prop trading desk 2
FINANCIAL INSTITUTIONS FEATURING INVESTMENT BANKS

Article 8
Bank to give better guidance over rates

I the role of central banks;
I some of the key official interest rates – Fed funds rate (used by the Fed) and the repo
rate (used by the European Central Bank and the Bank of England);
I the Federal Open Market Committee and the Monetary Policy Committee;
I role of yield curves;
I US Treasury bond market;
I getting an inside view of an investment bank;
I looking at the key activities of an investment bank;
I what is meant by an initial public offer?
I explaining a company default;
I primary and secondary markets;
I principal and proprietary trading explained;
I the impact of the credit crunch on investment banks.
23
Financial markets watch the new Fed

chairman
When you start reading the Financial Times regularly, you will quickly see how important
central banks are in terms of their impact on financial markets. This theme is a recurrent
one in the financial pages, as the actions of these banks have a massive impact on the
stock markets, the currency markets and the bond markets. They are normally in sole
charge of setting the level of short-term interest rates in each country. For example, in the
United States they are set the task of ensuring that the US economy operates at a level of
activity that is compatible with sustainable non-inflationary economic growth. In order to
achieve this target, the Fed meets most months to set the target level for the Fed funds
rate. It is really important that you understand the role of central banks in practice.
In this article we will see how closely financial markets follow the actions and statements
made by the people who run the main international central banks. There is no doubt the
main focus is on the chairman of the US Federal Reserve who is currently Ben Bernanke.
Article 5 Financial Times, 14 February 2006 FT
Bernanke to give a taste of more

transparent Fed
Andrew Balls
Ben Bernanke’s debut on Capitol Hill be speaking on behalf of the whole com-
this week will provide the first glimpse of mittee, and although the need for further
the more transparent approach he rate increases is a matter of debate among
intends to take as chairman of the members, the view that decisions will be
Federal Reserve. data-dependent is unanimous.
A host of Fed watchers expects more The FOMC said after its January
plain language from the new Fed chairman, meeting, at which it raised rates in the
in contrast to the Delphic approach of his 14th consecutive step to 4.5 per cent, that
predecessor, Alan Greenspan. ‘some further policy firming may be
Reflecting his belief that the Fed should needed’ to keep the risks to growth and
provide more quantitative guidance to inflation in balance. Futures markets are
market participants, Mr Bernanke is also pricing in another increase at Mr
expected to place much greater emphasis Bernanke’s first meeting as chair, in
on the consensus forecasts of the Federal March, to 5 per cent, and a good chance of
Open Market Committee Members. Mr another increase in May.
Greenspan, who did not participate in the John Lipsky, chief economist at
forecast round, often avoided mentioning JPMorgan, said he hoped that Mr
them in testimony. Bernanke’s commitment to greater trans-
But it is unlikely Mr Bernanke will parency meant he would provide more
provide much more detail on the likely detail on how the central bank would
course for the federal funds rate. He will judge when to end the campaign of
24
Article 5 Bernanke to give a taste of more transparent Fed
interest rate increases, to help guide February started providing two-year fore-
expectations. ‘To date, the Fed has been casts in the first monetary policy report of
singularly opaque on the criteria that will the year. Over such a period, monetary
be used to determine when the tightening policy would be expected to influence the
is sufficient’, Mr Lipsky said. outcomes, meaning that the committee’s
It is only when presenting the twice- inflation forecast for 2007 can be seen as 2
yearly testimony on the monetary policy an objective as well as a forecast.

report that the Fed chairman speaks for A number of Fed watchers expect a
the whole of the FOMC rather than in a slightly hawkish tone from the new
personal capacity. Mr Bernanke will chairman to help bolster his inflation-
appear before the House financial services fighting credibility. Fed policymakers were
committee tomorrow and on Thursday not troubled by the slowdown in the
before the Senate banking committee. economy in the fourth quarter and expect
Over time, Mr Bernanke is likely to strong growth in the first half of this year.
want to be more specific about the com- Lawmakers are also likely to quiz Mr
mittee’s outlook for interest rates and the Bernanke on the flat yield curve and the
assumptions used in making its forecasts. implications for the Fed’s deliberations.
A leading advocate of inflation targeting, At 4.5 per cent, the federal funds rate is
he is expected to introduce a more formal little different to the yield on the 10-year
inflation objective over time, but has said Treasury note.
this will require the FOMC’s support. Some economists see this as foreshad-
‘He can’t really focus on the innovations owing a slowdown in the economy.
he wants in this testimony, since he has just However, the view at the Fed is that low
arrived and he will be speaking on behalf of long-term rates are stimulating growth, a
the whole committee’, said Larry Meyer, a point Mr Greenspan is reported to have
former Fed governor and founder of the made at a meeting with hedge fund man-
consultancy Macroeconomic Advisers. agers, organised by Lehman Brothers, in
The consensus of FOMC forecasts is New York last week.
likely to show the economy growing Mr Bernanke has in the past stressed
slightly faster than its trend rate, com- that the Fed must take into account broad
monly put at 3–3.5 per cent, this year and financial conditions in setting the federal
slowing to trend growth in 2007. Core funds rate, including long-term interest
inflation this year is likely to be in the top rates, currencies and the stock market.
part of the 1–2 per cent comfort range, ‘I would like him to come out and say
popularised by Mr Bernanke when he was that the reason they are still raising rates
a Fed governor before joining the White is because financial conditions – long-term
House staff last year. rates, the dollar and equities – remain
In one of a number of steps towards accommodative. They are tightening the
greater transparency during Mr fed funds rate to keep financial accommo-
Greenspan’s tenure, the Fed last dation where it is’, Mr Meyer said.
I The analysis
The focus is on the first appearance of the new chairman of the Federal Open Market
Committee (FOMC) in front of the politicians on Capitol Hill. The FOMC is the body that
is in charge of setting the level of short-term interest rates in the United States. It meets
eight times per year and it can organise emergency conference calls if immediate action is
25
necessary. The Committee is chaired by Ben Bernanke who took over from Alan
Greenspan, the Fed’s best-known chairman, who held office from 1987 to 2006.
This Financial Times article argues that in comparison to his predecessor the statements
of the new Fed chairman should be easier to understand. Mr Bernanke was expected to
pay far more attention to the formal economic forecasts produced for the FOMC. The key
event discussed here is the so called ‘Humphrey Hawkins Testimony’ which is a biannual
statement made by the Fed chairman, first to House Financial Services Committee and
then to the Senate Banking Committee. Every word spoken on these occasions is closely
followed by the so-called ‘Fed Watchers’ who try to predict future changes in US interest
rates. Getting these forecasts correct can be worth a fortune to the money and bond
market traders inside the investment banks.
At its last meeting the FOMC had raised the target for the key Fed funds rate for the
fourteenth consecutive time to reach 4.5 per cent. Financial markets were looking for any
clues about when this period of Fed tightening would finally be over. Fed watchers were
hoping that policy-making would now become far more transparent. A key part of this
change in strategy was the expectation that Mr Bernanke would advocate a more formal
inflation target just like the ones used by the Bank of England and the European Central
Bank. It was also possible that at least initially he would adopt a more hawkish tone to
demonstrate his tough anti-inflation stance.
One key issue that economists have latched onto was the presence of an almost flat
yield curve. In simple terms this means that the level of interest rates is virtually the same
all the way from overnight money market rates right through to long-term US Treasury
bonds. There were two alternative explanations offered for this development. They had
sharply different implications for the economic outlook in the United States.
The first view was that the flat yield curve simply reflected the high level of short-term
interest rates that had effectively killed off any fears of rising inflation. This favourable back-
ground caused long-term bond yields to fall back in line with short-term interest rates.
There was some concern that this highly restrictive monetary policy would eventually lead
to a significant slowdown in the economy. The alternative view voiced by Alan Greenspan
was that the flat yield curve, was actually due to the presence of very low long-term bond
yields and this was a key factor behind the resilience of the US economy. Whichever view
best described the shape of the yield curve, there is no doubt that financial markets would
be watching closely Mr Bernanke’s every move in the coming months.
I Key terms
Fed watching This refers to the various economists who spend their time studying every
market movement or speech from a key official of the Federal Reserve Bank in order to try and
predict the next move in US interest rates. Getting these predictions right is worth a great deal
to the large investment banks as their traders can use these forecasts to make massive profits in
their bond, share and money market trading operations.
Fed funds rate This is the most important short-term interest rate in the United States. It refers
to the overnight inter-bank lending that takes places in the United States money markets. The
26
money that one bank lends to another comes from any excess reserves held at the Fed. All banks
have to hold a certain level of money at their local Federal Reserve District Bank. These deposits
are called required reserves.
The Fed funds rate – A simple example

Bank 1 2
Required reserves = $100 m

Actual held = $0 m
So it has a deficit = $100 m
Bank 2
Required reserves = $200 m
Actual held = $300 m
So it has an excess = $100 m
Bank 2 can lend the excess reserves to Bank 1.

The rate for this type of short-term loan is the Fed funds rate.
The Federal Open Market Committee (FOMC) This is the committee that decides on
changes in US monetary policy. It is made up of twelve individuals. The core seven come from
the Central Federal Reserve Bank (based in Washington) and the other five represent the various
Federal District Reserve Banks. One of these, New York, has a permanent place on the FOMC.
The other eleven banks share the remainder of the votes on a complex rotation system.
The FOMC reviews the outlook for the economy before deciding on the next move in interest
rates. At the end of the meeting a vote from the twelve members decides on the correct target
level for the Fed funds rate in the immediate future.
Transparency This is one of the key criteria used to assess a Central Bank’s performance. The
level of transparency at a central bank tells us how open it is in terms of any major decisions
that it makes. As a result we judge a central bank to be highly transparent if these actions are
clear and easy to understand.
Hint: For more information see Article 8 which has a much more detailed discussion of this term
in the ‘key terms’ section.
Yield curves The yield curve is a very important tool in financial markets. It is vital that you
understand this concept very well because it is often discussed in the Financial Times and it is a
key determinant of future economic growth.
So what is a yield curve? It is a graph that shows the current structure of interest rates or yields
right across the full range of maturities.
What do we mean by the ‘range of maturities’? Maturity simply means the length of time that we
are borrowing money for. So a company might take out a bank loan with a maturity period of
just three months. This means that in three months time they must repay this loan.
The ‘range of maturities’ refers to the different time periods which might run from very short-
term borrowing in the money markets (starting with overnight loans) all the way to extremely
long-term borrowing in the bond markets extending all the way to 40 years plus.
27
What do we mean by interest rates/yields? When an individual or a company borrows money

there is a cost that they have to pay in order to obtain the funds. If it is a short-term loan (up
to one year) this is normally referred to as an interest rate. So we might take out a one month
bank loan with an annual interest rate of say 8.5 per cent. This is the interest rate, or the cost
of obtaining the funds.
If a company needs to borrow funds for a longer time period this will normally be through
the issue of a bond market security which is usually repaid at a fixed rate of annual interest (this
is called the ‘coupon’) until it is finally repaid on the date that it redeems or matures. The yield
on the bond issue is the cost to the issuer or the return to investor who buys the bond.
The yield curve always shows the interest rate or yield plotted vertically with the maturity plotted
horizontally. The yield curve is described as being upward sloping (Figure 2.1) when the level of
interest rates/yields increases in line with maturity. This is the normal shape of the yield curve.
This is not surprising. You should expect the rate of return on your money to increase the longer
you invest your money. So you would expect a 5-year bond to pay a better rate of return than
a one-month deposit account. In addition the higher return on longer-term maturities also
reflects the risk that rising inflation will reduce the real return to the bond holder. This risk of
rising inflation will be greater on longer-dated bonds.
Yield
Upward sloping
Maturity
Figure 2.1 Normal or upward sloping yield curve
Sometimes the yield curve will take on a very different shape. For example, it can become
inverted or downward sloping (Figure 2.2). This tends to happen when the central bank tightens
monetary policy aggressively, resulting in a very high level of short-term interest rates.
Consequently, there is an expectation that the economy will slow down with very little threat
of rising inflation. As a result, the level of long-term bond yields will be relatively low reflecting
the expectation of low inflation rates.
28
Yield
Downward sloping
2

Maturity
Figure 2.2 Inverted or downward-sloping yield curve
Finally, there are times when the yield curve will become relatively flat (Figure 2.3). Indeed
this is the case with the US bond market at the time of this Financial Times article. There were
two alternative explanations for this development. First, the high level of short-term interest
rates, caused by the Fed’s aggressive tightening of monetary policy, had killed off any risk of
higher inflation. This resulted in long-term bond yields and short-term interest rates hitting
similar levels. The second explanation is that the presence of low long-term bond yields was
resulting in a very resilient economic background in the United States. This caused short-term
interest rates to be kept at a high level.
Yield
Flat
Maturity
Figure 2.3 Flat yield curve
10-year Treasury notes This refers to the US Treasury bond market. The US government issues
a range of ‘I owe you’ (IOU) certificates sold internationally to finance its budget deficit (the dif-
ference between its revenue and spending). The level of returns on shorter-dated US Treasury
bonds is influenced by the outlook for the economy which will determine the level of short-term
interest rates. The level of bond yields on longer-dated issues will be primarily determined by
29
the outlook for inflation in the United States. In the US all Treasury bonds are referred to as
Treasury notes until they go past maturities of 10 years. (See Article 9 for more details of the US
bond market.)
Tightening monetary policy When you see the term ‘monetary policy’ in the context of
central banks it refers to interest rate policy.
Central banks tighten monetary policy when they raise interest rates.
Central banks ease monetary policy when they cut interest rates.
In this article the Fed is coming to the end of a period of significant tightening in mone-
tary policy as they have raised interest rates in the last 14 consecutive FOMC meetings.
This restrictive monetary policy is designed to counter the other financial conditions that
remain accommodative. These include low long-term interest rates (which stimulates
lending), the buoyant level of share prices (which stimulates spending as people feel
wealthy) and the weaker dollar (which boosts US exports).
Hawkish In the context of central banks, commentators often use the terms ‘hawkish’ and
‘dovish’ to describe members of the Central Bank Committees who set interest rates. For
example, a hawkish member of the FOMC tends to be very concerned about maintaining a
clear anti-inflation policy and so is more likely to vote for an increase in interest rates. In con-
trast, a dovish member of the FOMC tends to be more relaxed about the inflation outlook and
as a consequence is less likely to vote for any increase in interest rates.

1. In the context of central banks what is meant by the term ‘transparency’?
2. The article suggests that the new Fed chairman might want to introduce a more formal
inflation objective over time. What do you think would be the advantages and disad-
vantages of such a move?
Hint: You might like to compare the Fed’s policy with the more formal inflation targets
that are used by the Bank of England and the European Central Bank.
3. Why has the FOMC raised the Fed funds rate at the last 14 consecutive meetings?
4. What are the two alternative explanations for the flat shape of the yield curve? What
are the implications of these views for the outlook for economic activity in the US?
5. What would the likely impact be of this slowdown on the US stock markets, bond
markets and money markets?
You will need the Companies and Markets section of the Financial Times.
Go to the Market Data section and look at the top right-hand side of the page.
30
In this section you will see various data on interest rates. You need to examine the section
that looks at the level of official rates.
Now answer these questions:
1. What is the current level of the Fed funds rate?
2. When it was last changed? 2
3. What was it a year ago?

4. How does the level of US official interest rates compare to the other major world
economies?
I Go to the web
Go the Federal Reserve’s official website: www.federalreserve.gov.
Find the section on the Fed’s monetary policy. Locate the latest minutes of the FOMC.
Look at the last few pages where the decision on interest rates is being discussed.
a. What were the main economic factors discussed by the FOMC at this meeting?
b. What was the target rate for the Fed funds rate set by the FOMC?
c. Can you identify any particularly hawkish or dovish members of the FOMC?
I Research
The best place to learn more about central banks are the official websites from the major central
banks. They all have a great deal of material on monetary policy and the key roles of the central
banks.
For reference you will find these at:
www.federalreserve.gov
www.ecb.int/home/html/index.en.html
www.bankofengland.co.uk
In addition you might find these references helpful:
Howell, P. and Bain, K. (2008) The Economics of Money, Banking and Finance, 3rd edn, Harlow,
UK: FT Prentice Hall. You should focus on Chapter 4, especially pp. 103–6.
Mishkin, F. and Eakins, S. (2008) Financial Markets and Institutions, 6th edn, Pearson Addison
Wesley. You should look at Chapter 6 on the Federal Reserve.
Valdez, S. (2007) An Introduction to Global Financial Markets, 5th edn, Basingstoke: Palgrave
Macmillan. You should look at Chapter 3. This provides a good general introduction to the role
of central banks.
31
The roller-coaster life of an investment

banker
The gap between these two articles was almost exactly two years. However, during this
period the state of the investment banking industry had gone from boom to bust. In the
wake of the credit crunch we had seen the demise of some of the premium names in this
sector including Lehman Brothers and Bear Stearns, and the rest had been forced to write
off billions of dollars due to the much reduced value of a wide range of their financial
assets. At the time of the second article the investment banking industry was in a perilous
state. However, these financial institutions are remarkably resilient and very skilled in
changing the nature of their businesses. They have a tradition of being able to reorganise
their operations and finding a series of new activities that will once again prove to be prof-
itable in time.
So, despite the difficulties that faced the industry, investment banking remains a very
attractive career combining real influence with enormous wealth. Certainly a significant
number of students decide to embark on the difficult search for a place on a graduate
training scheme with one of these prestigious institutions. With a starting salary as high as
£50 000 soon growing to six figures and the ultimate lure of seven figure bonuses, the
attraction is obvious. However, be warned, this is no easy ride. The hours can be horren-
dously long, and as a new graduate you are required to make a significant commitment
to the company. For example, you will be expected to stay and work on projects long into
the evening, sometimes through the night and at weekends. It is an extreme environment
which you will quickly grow to either love or hate.
How long can the good times last? Bankers

cautious despite bids and bumper bonuses
Peter Thal Larsen
At a private dinner in the City of group, as well as Nasdaq’s $5.1 bn bid for
London early last week, the top brass the London Stock Exchange.
at one of the Square Mile’s leading The flurry of deals capped what could be
investment banks were reflecting on a record year. Powered by cheap debt and
the tumultuous events of the past few buoyant equity markets, most investment
days. banking businesses expect to hit new highs
In 24 hours, takeovers with an aggre- in profitability, surpassing records set in
gate value of $75 bn (£38.8 bn) had been 2000, at the peak of the dotcom bubble.
unveiled. These included the largest This will fuel a new round of bumper
private equity deal on record – bonuses in the City and on Wall Street, as
Blackstone’s $36 bn offer for Equity Office bankers whose earning power has been
Properties, the commercial real estate eclipsed by traders in recent years once
32
Article 6 How long can the good times last? Bankers cautious despite bids and bumper bonuses
again climb up the compensation league cycles less relevant. Memories of the
tables. painful downturn in 2001 and 2002, when
Yet the mood round the dinner table investment banks slashed costs as activity
last week was cautious, even bordering on dried up, are still vivid.
the pessimistic. Bankers marvelled at the That said, there is little to suggest an
aggressive takeover bids, shook their impending downturn. Long-term interest 2
heads at the amount of leverage some rates are still low and economic growth

companies were willing to take on, and prospects relatively benign. Surplus savings
warned that it could not last. built up in Asia and the Middle East are still
Whether in New York, London or Hong being recycled in the capital markets.
Kong, dealmakers acknowledge they are The market has also proved remarkably
operating in a near perfect environment. resilient to shocks: the collapse of
Low long-term interest rates, combined Amaranth, the hedge fund that lost $6 bn
with the globalisation of capital flows and betting on US gas prices, barely registered.
booming demand for raw materials and Barring a large-scale terrorist attack, a
energy have created the ideal incubator widespread outbreak of avian flu, or
for deals. another war in the Middle East, few can
Despite the rise in short-term interest see what will cause the cycle to turn.
rates this year, investors searching for That said, there are signs of excess.
additional yield are still piling into the Bankers point to the competing bids for
leveraged finance market, allowing Corus, the Anglo-Dutch steelmaker, and
private equity groups and companies to the offer for Qantas, the Australian
finance large acquisitions with cheap debt. airline, by a consortium of private equity
Volatility in the equity markets has and infrastructure groups as signs that
declined, making it easier to launch initial lenders are now willing to apply financial
public offerings. ‘The stars are still leverage to industries that were tradition-
incredibly well aligned and there’s rightly ally not seen as sufficiently stable to
a fear that this can’t last’, says Franck service large amounts of debt.
Petitgas, head of European investment Shareholders in companies that are on
banking at Morgan Stanley. ‘But my sense the receiving end of takeover bids have
is we are in an environment that still is also become more demanding: despite con-
very good for our business.’ cerns about competition and the absence
By their very nature, investment bankers of any credible rival buyers, investors in
tend to be optimists. But in private, many the London Stock Exchange responded to
agree conditions can only get worse. Default Nasdaq’s bid by pushing the shares well
rates on the most speculative grades of cor- above the US exchange’s ‘final’ offer.
porate debt, now at lows, will rise. Equity But some are becoming more cautious.
markets will become more volatile and cor- Merrill Lynch’s monthly survey of fund
porate executives less confident. managers for November showed cash bal-
‘We just have to carry on making hay ances had increased from 3.8 per cent in
while the sun shines’, says one London- the previous month to 4.1 per cent, while
based dealmaker. one in five fund managers had an over-
The cautious mood is in striking con- weight position in cash.
trast with the peak of the last cycle in Last week, more than 100 of Lazard’s
2000. At the time, many bankers argued top investment bankers cashed in shares
that the buoyant market could continue worth about $300 m; their first oppor-
indefinitely, and that the impact of new tunity to sell shares since Lazard’s IPO
technology had made traditional business last year. Shares in the independent
33
investment bank, which is heavily geared M&A volumes

Annual total ($’000bn)
to the M&A cycle, are up 80 per cent since
4.0
joining the market.
3.5
Investment banks are also hedging 3.0 Global
their bets by preparing for a downturn. 2.5
Goldman Sachs has hired several bankers 2.0
1.5 US
who specialise in bankruptcies and
1.0
restructuring work while one of the 0.5 Europe
bank’s funds has handed $685 m to 0 UK
Wilbur Ross, the leading distressed debt 1997 2000 02 04 06
YTD
investor.
Perella Weinberg, the newly created Average loan yield spread*
investment banking boutique, recently Over Euribor, basis points
recruited a top Wall Street bankruptcy 325
adviser.
Europe
Despite their willingness to underwrite
debt offerings for leveraged buy-outs, 275
banks also appear to be pulling in their
horns. Simon Maughan, an analyst at 225
Blue Oak Capital, points out that asset US
growth in the UK banking industry has
slowed sharply this year after reaching a 175
Nov 2006 Nov
peak of more than 20 per cent. 2005 * Secondary market
Previous slowdowns have been associ-
ated with slowing revenues. ‘Our thesis is UK resident banks’ asset growth
that excess liquidity in the global economy Per cent
has allowed banks to create more and 25

more derivative products from a stock of 20
debt and equity. This is banking alchemy, 15
the ability to turn a given asset into new 10
money-making opportunities several 5
times over’, he says. ‘The current boom in 0
banking revenues is thus a liquidity –5
bubble, like many others throughout
–10
history, and the major question is when it 1991 94 96 98 2000 02 04 06
will end. That is, if it hasn’t already.’
Few bankers are willing to call the top Equity volatility
of the cycle. Some point out that regula- VIX index
tors and credit ratings agencies have been 25

warning about a possible turn for several
years. Besides, if there is a slowdown this 20
does not mean the market will collapse.
15
One senior investment banking executive
argues expectations of a downturn make
10
it less likely to occur.
‘It’s only when everyone begins to 5
believe that this will go on for ever that Jun 2006 Nov
we really need to start worrying.’
34
I The analysis
Investment banks are very powerful financial institutions that are right at the heart of most
corporate finance activities reported in the Financial Times. It is useful to split them into
two parts. The Investment Banking Division (IBD) will work with the issuers of new capital.
So they will advise on new primary market issues of debt or equity. The clients of the IBD
2
will be mainly companies and governments. At the same time the Markets Division focuses

on the trading of existing issues in the secondary market. The clients of the Markets
Division will be the main investors in capital market products. This will primarily be the
pension funds and the insurance companies.
This Financial Times article clearly sets out the conditions that have created the ‘near
perfect environment. Low long-term interest rates, combined with the globalisation of
capital flows and booming demand for raw materials and energy have created the ideal
incubator for deals.’ Investment banks rely on new deals to keep them busy and to justify
their enormous fee income. This has led to a record level of bonuses being paid to the
directors in the Investment Banking Division.
However, faced by this boom period, there is not surprisingly a mood of some caution
creeping in, since many insiders believe we are reaching the top of the cycle. There are
signs of excesses appearing, and the article cites the increasing willingness of the banks to
lend large amounts to industries like steel and the airlines which have been traditionally
seen as too risky to service large amounts of debt finance. In addition, the investment
bankers at Lazard Brothers recently sold some $300 m of shares in their firm following the
initial public offer (IPO) in 2005. Other investment banks are beginning to ready them-
selves for a downturn by hiring staff specialising in bankruptcies and corporate
restructuring.
As usual there are mixed views on the exact timing of the top of the market, and the
catalyst for this reversal of fortunes is never clear until it happens. However, the one thing
we know is this business is highly cyclical and a wise investment banker is always planning
for the downturn. We might soon see the following advert in the classifieds section of the
Financial Times:
Second hand Ferrari for sale.

£50 000 ono.
One careful investment banking owner.
Only 5000 miles on the clock.
He was too busy to get to drive it!
35
Article 7 JPMorgan to cut prop trading desk
JPMorgan to cut prop trading desk

Francesco Guerrera, Justin Baer and Jeremy Grant
JPMorgan Chase is to scrap its standalone their own capital to work and exploit
proprietary trading desk, highlighting favourable market conditions.
how the dearth of investment oppor- Proprietary trading became an
tunities is prompting banks to retreat important source of profit for Wall Street
from in-house hedge funds that had companies such as Goldman Sachs and
thrived before the turmoil. Morgan Stanley, as well as their European
People close to the situation said the counterparts.
decision to fold the 80-strong global pro- Banks do not publish results of their
prietary trading unit into JPMorgan’s proprietary trading units, but analysts
other trading operations could result in estimate that many of them suffered sig-
job losses. The bank is believed to be nificant losses on mortgage securities and
looking at other areas where operations other toxic assets when the financial
overlap and could announce further reor- boom turned to bust last year.
ganisations and job cuts in months to A senior official at a US brokerage
come. JPMorgan, which has acquired the house based in London said: ‘I think a lot
investment bank Bear Stearns and the of people are taking a step back and
regional lender Washington Mutual, has looking at their risk matrices from top to
already announced 4100 job cuts, bottom, and working out whether they
according to Bloomberg data. have good risk models in place.’
JPMorgan’s move, announced in an JPMorgan declined to comment, but
internal memorandum, is a sign of people close to the company said that
financial groups’ reluctance to deploy merging the unit that used the group’s
their own capital on large trading pos- own capital with the operations that
itions amid uncertain market conditions. trade equities, fixed income, commodities
‘Our business and industry have and other assets on behalf of clients
changed dramatically this year and within would reduce duplication and increase
this new market paradigm, the advan- efficiencies.
tages of aligning our proprietary trading Until the expected completion of the
activities with the core business are clear’, merger of the two groups at the end of the
Steve Black and Bill Winters, co-heads of month, the proprietary unit will not be
JPMorgan’s investment bank, said in the allowed to place any new trades,
memo, which was obtained by the according to people close to the situation.
Financial Times. People close to JPMorgan said the move
The disappearance of JPMorgan’s sep- would not necessarily mean that the bank
arate proprietary trading desk, which would reduce its proprietary trading
mirrors similar moves by rivals, is a activities but added that, in the short
reversal of the strategy followed by many term, that was likely. They argued that
financial groups in the recent past. the markets’ convulsions of the past few
During the years that preceded the months made it difficult and riskier for
current turmoil, most large banks rushed any bank to place proprietary trades with
to create in-house hedge funds to put its own capital.
36
Article 7 JPMorgan to cut prop trading desk
I The analysis
At the end of the analysis of Article 6 I suggested that, despite the boom times for invest-
ment bankers in the autumn of 2006, they might soon find conditions much tougher. That
was one prediction that came right very soon. This article focuses on the impact of these
more challenging times on the US investment bank JPMorgan Chase. Earlier in the year
2
they had hit the headlines when they played a pivotal role in rescuing the cash-strapped

investment bank Bear Stearns from the brink of collapse. JPMorgan Chase bought out the
assets of Wall Street’s fifth-largest investment bank for a fraction of its previous value. They
paid just $236 m for a financial institution that had been valued at over $140 bn before
the credit crunch had undermined confidence in the bank.
A few months on from this deal JPMorgan Chase was back in the news, this time acting
to reduce its own risk within their trading teams. An internal memo written by Steve Black
and Bill Winters, the co-heads of JPMorgan’s investment bank, confirmed that they were
acting to close an 80-strong global proprietary trading team. It is important to explain the
significance of this development. Proprietary trading is where the investment bank uses its
own capital to take a trading position in the hope of making a significant financial gain.
For example we might have an equity proprietary trader who thinks that the share price
of Barclays Bank has fallen too far. They buy 1 million shares in Barclays for, say, £2.50
each. If they are right and the share price rises to £3.50 in the next week or so, they will
make:
1 m x £1 = £1 m for the bank.
However, if instead the share price falls, this trade will run up huge losses.
You should see that proprietary trading is just about the most risky thing that an invest-
ment bank does! So at a time of huge financial market uncertainty we should not be too
surprised to see the investment banks curtailing these activities.
However, the decision to cut back on the activities of proprietary trading teams
was quite a departure for the banks. Prior to the credit crunch these investment banks
had spent large amounts of money developing in-house investment funds which
aimed to use the bank’s own capital to make money from these types of trading
activities. However, it was clear that in the new world where the focus was on risk
reduction this was one type of activity that would be on the back burner at least for
a while.
I Key terms
Investment banks An investment bank acts as an intermediary between the issuers of capital
(governments and companies) and the investors in capital (pension funds and insurance
companies). They are normally split into four divisions:
Bonds – new issues

Equities – new issues
Merger and acquisitions (M&A)
Real estate (property).
37
Article 7 JP Morgan to cut prop trading desk
Their staff will work either in the investment banking division (IBD) which deals with the new
issues of debt and equity capital or the markets division which deals with the investors in new
bond and equity deals.
The people who work in the IBD division will typically work on several projects. As an
example this might involve meeting a company to suggest that they should take advantage of
favourable market conditions to launch a new international bond issue. This will involve the
senior staff making a presentation to the finance director/CEO of the company involved.
Proprietary trading This is where the investment bank uses its own capital to fund trading
strategies that are designed to earn them significant profits. This form of trading can be in a
wide range of financial markets.
Real Estate Group This is a key division within an investment bank that deals with any aspects
of commercial property deals.
Primary and secondary market The IBD will work with companies with their initial issue of
new shares. This is called the ‘primary’ market. The markets division will then work in the sec-
ondary market which is where new buyers can purchase these shares from existing holders. This
is normally a standard marketplace like the Stock Exchange’s official list.
Hedge fund These are specialised funds that use large amounts of borrowed money to invest
in bonds, equities, currencies or various derivative products. They take more risk than a trad-
itional investment fund in the hope of making much higher returns.
Leveraged This refers to the capital structure of the new company being formed. The term
‘leveraged’ suggests that the company will be financed largely by borrowed money.
Default This is where a borrower takes out a loan but fails to keep to the original agreed schedule
of interest payments and final capital repayments. A bond issued by the United States or United
Kingdom government is generally regarded to be free of default risk. In contrast, a bond issued
by a company might well have significant risk of default. For example, a company might not be
able to keep up with the interest payments on the loan as a result of a downturn in its profitability.
Initial public offer (IPO) In the primary capital market this is where a company makes its first
issue of shares. These IPO’s are organised by investment banks who charge substantial fees to
their clients for this service.
Mortgage-backed securities This is where a large amount of mortgage debt is pooled

together and then sold to a different set of investors in the form of a securitised financial market
instrument. During the credit crisis the existence of these securities was at the heart of the multi-
billion dollar write-offs required at many of the banks.

1. Describe the main functions of an investment bank.
2. Explain the various factors that have contributed to the ‘near perfect environment’ for
the investment banking industry during 2006.
3. How did the investment banks react during the last downturn between 2001 and
2002?
38
Article 7 JP Morgan to cut prop trading desk
4. What were the main risks that threatened the outlook for the investment banking
industry at this time?
5. What is meant by the term ‘proprietary trading’?
6. Why did many investment banks suffer large losses on proprietary trading in mortgage-
backed securities and other toxic assets?
2
7. What are the main risks that investment banks face?

8. It has been argued that in the search for extra profitability retail banks had made a
grave mistake in allowing their investment banking arms to take on excessive risks. To
what extent does this show that there is a fundamental problem in trying to combine
retail and investment banks in one business?
I Go to the web
Go to the website for Barclays Capital Investment Bank at www.barcap.com.
Take a look at the main sections (on the left-hand side)
Financing
Risk Management
Investment Banking
Distribution, etc.
You are now required to write a short note (500 words max) explaining what each of these
key areas does in practice.
I Research plus careers advice:

Edition. The role of investment banks is briefly mentioned on p. 340.
Valdez, S. (2007) An Introduction to Global Financial Markets, Basingstoke: Palgrave Macmillan.
You should look at Chapter 5. This contains a very good introduction to the role of investment
banks.
In addition, most of the large investment banks have excellent websites. You will often get some
outline of some recent corporate activities that the banks have worked on.
These sites also include advice on careers in most areas of the bank. This might include details
of useful internships that the investment banks run. They are an excellent way to gain an insight
into a career in this sector. Be warned: if you want to apply to an investment bank, they have
very early closing dates normally in the January before their next graduate training scheme
starts.
A few examples of these investment bank websites are:
www.nomura.com/europe (Nomura)
www2.goldmansachs.com/uk (Goldman Sachs)
www.jpmorgan.com/pages/jpmorgan/investbk (JP Morgan)
39
More transparency needed at the Bank of

England
Whenever I write about the Bank of England it always makes me feel slightly uneasy. This
is because back in 1997, when I was combining an academic career with consultancy work
in the City, I happened to be talking to an audience of fund managers on the day the new
Labour government came to power. I was asked if I thought the new government would
make the Bank of England independent and allow it to set UK interest rates free of inter-
ference from the politicians. My answer was confident and short. I said: ‘There is no
chance of that happening; who waits 18 years to gain political office and then gives up a
major instrument of economic power?’ The next day I opened my Financial Times and saw
with horror the headline ‘Chancellor Brown to make Bank of England independent’.
Bank to give better guidance over rates

Chris Giles and Scheherazade Daneshkhu
The Bank of England has pledged to give monetary policy by code word’, the prac-
financial markets a better idea of the cir- tice by which the Federal Reserve and
cumstances that are likely to trigger the European Central Bank use par-
interest rate changes. ticular phrases to signal future rates
The undertaking follows mounting crit- decisions.
icism of the bank’s communications policy But he added that he viewed favourably
as it celebrates the 10th anniversary of its the demand from City economists for
independence to set interest rates. ‘something to guide them how to inter-
Mervyn King, governor, told the pret the future data as they come out, as
Financial Times that the central bank they want to know how we are likely to
was ‘clearly’ failing to explain properly to interpret that data’.
markets how it was likely to respond to ‘It will require quite a lot of hard work
economic data. on our part in thinking it through, but I
Futures markets have bounced errati- think we should do it’, he said, telling the
cally this year as investors struggled to FT the Bank was ‘clearly not doing
understand the Bank’s thinking in raising enough of it now – which is to give people
interest rates by a quarter-point to 5.25 this feel for how we are likely to react to
per cent in January. data’.
A Reuters poll of 49 City economists Looking back over the past decade, Mr
yesterday found 25 saying that the Bank King said he was convinced that the
had become less effective in communi- Bank’s independence had improved
cating policy over the past year. Britain’s economy. From being the lowest
In a speech last night, Mr King ranked Group of Seven economy before
rejected the idea of publishing a forecast 1997, the UK had moved towards the top.
for interest rates. Speaking to the FT, While other factors were also at work,
he insisted the Bank would not ‘do the governor insisted that the strong
40
Article 8 Bank to give better guidance over rates
belief among the public that inflation that I would find the most attractive’,
would remain low ‘has been fundamen- he said.
tal’. On the topic of appointments to the
Mr King repeated earlier comments Monetary Policy Committee, Mr King said
that bank officials ‘weren’t terribly enthu- he did not think there was ‘anything basi-
siastic’ about the 2003 change in the cally wrong with the process’. 2
inflation target to the consumer price An FT survey of 13 of the committee’s

index, partly because this measure 14 past members, however, found a
excluded housing costs. majority suggesting that the process
He also said that current efforts by should be overhauled.
Eurostat, the European statistical agency, Professor Willem Buiter, who served
to include housing were late and unsatis- between 1997 and 2000, argued: ‘The
factory. process for internal members is com-
‘I must say that the experiments pletely non-transparent. For external
they’ve been carrying out have not members it is both completely non-trans-
been with measures of housing costs parent and a shambles’.
I The analysis
The key activity of the Bank of England’s Monetary Policy Committee (MPC) is to set the level
of the repo rate which is consistent with the government’s 2 per cent target for consumer
price inflation in the UK. The MPC meets at the start of every month and it has a detailed dis-
cussion of the current state of the economy before deciding on the right level of interest rates.
It comprises five members appointed from within the Bank of England and four external
members. The latter members normally come from academia, industry or the trade unions.
Financial markets watch the MPC meetings very closely, trying to predict any future
moves in interest rates. In January 2007 the MPC surprised virtually every City economist
with the decision to raise the repo rate by 25 basis points to 5.25 per cent. One reason for
the shock was that the previous meeting had reached a unanimous decision to hold rates
at 5 per cent and the markets did not expect any increase in interest rates at least until the
inflation report was published in February 2007. After this move the markets became con-
cerned that the Bank of England either had an early sight of some bad economic news or
that it was radically changing the way that it was reacting to published economic data.
Either way the markets were confused and sought immediate clarification.
One sign of these worries is well stated in this Financial Times article. As it says ‘the
futures markets have bounced erratically this year as investors struggled to understand the
Bank’s thinking in raising interest rates by a quarter point in January’. Normally these
markets are an excellent guide to future interest rate policy. If you want to get a good indi-
cation of how official interest rates will move in the next twelve months, you just look at
‘one-year’ sterling Libor rates in the money markets. However, in recent times these futures
rates have become very volatile, reflecting the uncertainty about what drives official
interest rate policy in the UK.
In this latest speech by the Governor of the Bank of England, Mervyn King rejected the
formal publication of an interest rate forecast. This policy might be considered too
41
inflexible and in addition he was not keen to follow the Fed or the European Central Bank
in using various ‘code words’ to signal future interest-rate decisions. However, the markets
would like to be given more insight into the relative importance of various economic data
releases and to see how the Bank of England interprets this data. For example, in terms of
the inflation outlook what is the relative importance of wage costs versus other important
inflationary factors such as raw materials or housing costs?
The Governor also confirmed that the Bank of England was not keen on the decision in
2003 to change the measure of inflation being tracked by the government. The move then
was to abandon the Retail Price Index (RPI) in favour of the Consumer Price Index (CPI).
This was a significant change designed to bring UK inflation measures more into line with
other European countries. However, there are severe problems with the CPI as it does not
include council taxes and mortgage interest payments. These factors have both been
partly responsible for the sharp rise in the RPI which has led to calls for compensating pay
rises especially in the public sector.
Finally, the Governor turns to the controversial area of the appointment of members of the
MPC. A previous member of the MPC, Willem Buiter, said ‘the process for internal members
is completely non transparent. For external members it is both completely non-transparent
and a shambles’. Some of this criticism followed the appointment of David Blanchflower who
teaches at Dartmouth College in the US. It has been argued it is fundamentally wrong to
appoint someone who lives outside of the UK as an external member of the MPC. I am not
sure that I agree with this view. However, I might be somewhat biased. This is because back
in 1977 Mr Blanchflower had the misfortune to have to teach A-level economics to one less
than brilliant pupil. However, as an inspirational teacher he helped this pupil to achieve a
good A-level grade and he even persuaded him to go onto university to study Economics
further. Perhaps, it is a little late now but I would just like to record my sincere thanks to him!
I Key terms
Monetary Policy Committee The Bank of England’s Monetary Policy Committee (MPC) is in
charge of setting UK interest rates. It is made up of nine members:
The Governor
Two Deputy-Governors
Two Bank of England Executive Directors
Four independent members.
They are required by the government to ensure that the UK economy enjoys price stability. This
is defined by the government’s set inflation target of 2 per cent.
Repo rate This is the UK’s official interest rate which is used to supply funds to the money
markets through sterling money market operations. On the Bank of England’s website it states
that the Bank of England’s first objective in the money market is that ‘overnight market interest
rates [are] in line with the Bank’s official rate, so that there is a flat money market yield curve,
consistent with the official policy rate, with very limited day-to-day or intra-day volatility in
market interest rates at maturities out to that horizon’. Put simply, this means that they try to
impose their repo rate target on the UK’s money markets.
42
Retail Price Index/Consumer Price Index Until 2003 the UK government’s target for inflation
was set in terms of the percentage annual increase in the average prices of goods and services
as measured by the Retail Price Index (RPI). There was some controversy in 2003 when the rel-
evant inflation measure was changed to the Consumer Price Index (CPI) which excludes certain
important costs such as council tax and mortgage interest payments. If you want much more
information on this go to the National Statistics website at www.statistics.gov.uk. 2
Futures markets In the money markets there is a well-established futures market that allows

banks to deal at a set interest rate for a transaction on a specified future date. For example, a
bank could arrange to lend £10 m to another bank at a set interest rate on a specific date in
the future. The attraction of this deal is that both parties know now what the interest rate is
going to be. There is no uncertainty as this transaction will not be affected by any subsequent
rise or fall in money market interest rates.
London Interbank Offered Rate (Libor) If you look at the Market Data (in the Companies and
Markets section of the Financial Times) you will see a column marked ‘Interest Rates’. In this
column you will see interest rates for US$, € Libor and £ Libor. Libor stands for the London
Interbank Offered Rate. This is the rate used for loans made to low-risk banks in the London
money markets. You can get a Libor rate for a wide range of money market maturities. It starts
with overnight money and then goes to one month, three months, six months and one year.
The Libor for sterling is set each day by 16 banks including Abbey National, Barclays Bank,
Citibank, JPMorgan Chase and the Royal Bank of Canada. On the day I wrote this case study
(18 June 2007) the one-year rate was 6.11 per cent compared to 5.61 per cent for overnight
money. This suggests that the money market traders were expecting a further 50 basis points
increase in official interest rates in the next year.
During the first part of September 2007 there were dramatic events in the UK money markets
in the wake of the US sub-prime loan crisis. There were concerns that some banks had a signifi-
cant exposure to the resulting bad loans in the US. As a result the banks became reluctant to
lend money to each other. This had a significant impact on the UK interbank money markets
with three-month Libor rising to a nine-year high of 6.8 per cent.
Transparency This refers to the methods used by the central bank to make information avail-
able about the process of setting interest rates. The term ‘transparency’ refers to how open this
is in practice.
We could, for example, rank the Bank of England out of a score of five on the basis of three
measures of transparency:
1. Publication of minutes of the MPC: Score = 4.5/5
They are very clearly written and they state the range of factors used to decide on the
correct level of short-term interest rates.
2. Timing of publication of minutes: Score = 5/5
The minutes are published about two weeks after the meetings take place.
3. Inflation target: Score = 4/5
The inflation rate that the Bank of England targets is set by the UK government.
Total score = 13.5/15 which makes it highly transparent.
43
However, there is one aspect of the MPC that is possibly less than transparent. This is discussed
at the end of this article where there is a suggestion the current policy of selecting internal (from
within the Bank of England) and external (from outside the Bank of England) members of the
MPC is non-transparent. This means that to any outsider the selection procedure and criteria
are unclear.
Group of Seven This refers to some of the most influential economies in the World including
the United States, Germany, Japan, France, UK, Canada and Italy. They meet regularly to discuss
economic policy. These days their meetings often involve Russia (so it is really a G-8 now).

1. What are the disadvantages in the Bank of England publishing a formal interest rate
forecast?
2. Explain what is meant by the Bank of England’s repo rate.
3. What is the main role of the Bank of England’s Monetary Policy Committee?
4. Explain the difference between the Retail Price Index and the Consumer Price Index.
5. Why have there been calls for greater transparency in terms of the way that the
Monetary Policy Committee works?
6. In September 2007 we saw the three-month sterling Libor rate hit a nine-year high at
6.8 per cent. Give reasons for this sharp rise in Libor and discuss the possible implica-
tions for both savers and borrowers.
You will need the Companies and Markets section of the Financial Times. Go to the Market
Data section and look at the middle right-hand side of the page. In this section you will
see various data on interest rates. You need to examine the section that looks at the level
of market rates.
Answer these questions:
1. What is the current level of £ Libor overnight?
2. What is the current level of £ Libor three months?
3. What is the current level of £ Libor six months?
4. What is the current level of £ Libor one year?
On the basis of these answers give a clear explanation of the market’s view of the Bank of
England’s interest rate policy in the next year.
I Go to the web
Go the Bank of England’s official website at www.bankofengland.co.uk.
Find the section on monetary policy. Locate the latest minutes of the MPC. Read these
minutes and take some brief notes.
44
a. What were the possible interest rate options that were discussed by the MPC?
b. What was their final decision?
c. Were there any members of the MPC who dissented?
I Research 2
The best places to learn more about central banks are the official websites of the major central

banks. They are all fantastic learning resources with a great deal of material on monetary policy
and the key roles of the central banks. You will also see a wide range of current data on infla-
tion and interest rates.
It is also essential to read the Financial Times just after the major meetings of the central banks.
These articles appear in the main section of the paper.
Hint: Look in the headlines for references to the FOMC, MPC or the key interest rates.

45
Topic 3
Financial markets
If you are going to read the Financial Times successfully on a regular basis you must get to
grips with the daily movements in the world’s main financial markets. If there is a major new
story, you will normally find it on the front page of the main section of the paper with more
analysis in the Lex column on the back page. The feature article included here looks at the
impact that rising bond yields might have on the outlook for share prices around the world.
Financial markets exist to facilitate the transfer of funds from people who have excess
funds (the lenders) to those who have a deficit of funds (the borrowers). The lenders
include individuals, banks, pension funds and insurance companies. The borrowers
include individuals, companies and governments. If we examine the individuals, the
concepts of excess and deficit funds should become much clearer. If you are at the stage
of studying at university or just starting out on a career, it is very likely that you have a
financial deficit. Your spending will be greater than your earnings. This is only to be
expected. You are investing time and money partly in the hope of securing a well-paid
job after graduation. When this happens, you can start to repay your loans and
eventually when your income rises you might even get into a position of having a
financial surplus. At this stage you will invest your surplus money in a bank or in some
shares. This cash will find its way to one of the individual or corporate lenders probably
via a financial intermediary like a bank.
The way that cash moves from lenders to borrowers is normally through one of the
financial markets that have been created for this purpose. The various financial markets
are there to meet the specific requirements of its participants. We can see this by briefly
introducing each of the existing major markets:
1. The money market. This allows banks with surplus cash to lend these funds to banks
with a financial deficit. The key characteristic of this market is its short-term nature.
Money market securities are defined as having a maturity of anything up to one year.
The key interest rate that is traded in this market is called the London Interbank
Offered Rate (Libor). This is the rate used for loans made to low-risk banks in the
London money markets. You can get a Libor rate for a wide range of money-market
maturities. It starts with overnight money and then goes to one month, three months,
six months and one year. This is the market that saw a sharp reduction in liquidity in
the wake of the credit crunch.
2. The bond markets. Many of the borrowers need to obtain funding for much more
than one year. This will include governments, companies and banks that can all
access the bond markets to issue longer-term securities.
3. The equity markets. These markets allow the lenders to contribute risk capital to a
Financial markets
range of different businesses. They lend their money to these companies without a
guarantee of any capital repayment or dividend income in the future. This makes it a
risky form of investment but with the possibility of securing very high rates of return
at a later stage.
4. The foreign exchange markets. These allow people to convert one currency into
another. For example, a Japanese investor can exchange Yen for US dollars and use
the proceeds to buy some government bonds issued by the United States Treasury.
You will see this discussed in detail in Topic 12, which covers international econ-
omics.
5. The derivative markets. These are the financial instruments which have been devel-
oped to allow investors to manage and exploit risk. The name derivative is used
because they derive from the fundamental financial products outlined above. The
most common examples are futures, options and swaps.
It is likely that as you study finance you will start to develop a keen interest in the
trading and performance of these financial markets. I often find that my own students
become keen to try their hand at real trading by forming small investment clubs. This is
a good way to start to establish a feel for the factors that drive the prices of financial
market securities. My advice would be to at least start by not playing with real money
but rather just create fictional portfolios and then measure your performance over time.
You will quickly see whether you have the right skills needed to become a successful
market guru.
The following three articles are analysed in this section:
Article 9
Surprising US job creation data rally stock markets and dollar
Financial Times, 2–3 June 2007
Article 10
Bond yields spark credit concerns
Article 11
Bond market sell-off

I the US unemployment and non-farm payroll data;
I key stock market indices;
I the impact of economic releases on financial markets;
I what is meant by benign credit conditions;
I relationship between bond yields and economic activity.
48
At 1.30 p.m. in London all eyes are on the

screens
Every day financial market traders sit at their desks surrounded by a vast array of electronic
news services. They wait nervously for the latest economic data to hit their screens and
3
send the financial markets into a trading frenzy. Even though it is many years ago since I
FINANCIAL MARKETS
sat with them, I can still remember the intense feeling of anticipation ahead of these occa-
sions. My role back then was to sit with the government bond traders and give my instant
reaction as the new data was published.
The banks take huge trading positions ahead of these economic releases. The resulting
market movements determine whether the traders make serious profits or losses. Their
future employment and lucrative bonuses are determined by these outcomes. Moments
of joy can be fleeting as they are replaced by anguish as a market goes into freefall.
In terms of economic releases the absolute highlight is the employment data from the
United States. It is always published at 1.30 p.m. London time on the first Friday of each
new month. This release often sets the tone for the later releases and it can cause major
shifts in market expectations.
Article 9 Financial Times, 2–3 June 2007 FT
Surprising US job creation data rally stock

markets and dollar
FT reporters
The US economy appeared to be pulling five-year lows at 4.5 per cent, the govern-
out of a stall yesterday as figures showing ment said.
surprisingly strong job creation and Surprisingly, no net loss of construction
factory expansion pushed stocks into jobs was reported, in spite of the severe
record territory. weakness in the housing market.
With inflation also slightly softer, there The service industries accounted for
is little immediate pressure on the Federal the overwhelming majority of new jobs
Reserve to change interest rates in either with an increase of 176 000 in sectors such
direction. as banking and restaurants.
Alan Ruskin, a currency strategist at Peter Kretzmer, an economist at Bank
RBS, said the figures ‘should send of America, said: ‘The resilience of the
another dagger in the heart’ of those labour market will reassure policymakers
investors betting that the Fed would cut and market participants that job demand
rates. remains relatively healthy’. He added that
Employers added 157 000 staff to their the figures would allow ‘the central bank
payrolls last month following an increase to maintain its focus on core inflation’.
of 80 000 the previous month, while the The demand for staff was seen as a sign
unemployment rate held steady, near to that the economy was snapping back from
49
Article 9 Surprising US job creation data rally stock markets and dollar
its anaemic performance in the first was 0.1 per cent higher against the euro
quarter. It sparked a rally in the dollar. at $1.3430 and 0.3 per cent up against the
Labour income also grew at a healthy yen at 122.09.
rate, offering support for consumer In early trading, the S&P 500 index was
spending in spite of the higher petrol price 0.6 per cent higher at 1,539.69, while the
drag. Nasdaq Composite was up 0.7 per cent at
Bond prices fell as the yield on the 2,623.11. The Dow Jones Industrial
benchmark 10-year Treasury note rose Average was 0.4 per cent firmer at
5.3 basis points to 4.945 per cent. 13,687.77.
The dollar rose to its highest level
Note: reporting by Eoin Callan and Krishna Guha in
against the yen in nearly four months and Washington, Neil Dennis in London and Richard
to a seven-week high against the euro. It Beales in New York.
I The analysis
There are many different economic releases published each month. So how can we assess
the expected financial market impact of each bit of data? One way to do this is to put
them through a three-step screen test to judge their relative importance.
Test 1
What impact do the data have on economic policy making in a particular country? This is
important because economic releases become significant if they force changes in econ-
omic policy-making.
Test 2
How reliable are the data in this economic release? What does this mean in practice? A good
analogy would be if you went to your optician for an eyesight test and he used equipment that
gives an initial reading that will be revised to a more accurate level at a later stage. If the initial
reading shows that your eyesight is nearly perfect but this is later revised to show that you are
in fact seriously short-sighted, you would rightly conclude that the first test was totally unreli-
able. In the same way we should not regard any economic release that is likely to be heavily
revised later to be sufficiently reliable to impact on financial markets. So any economic release
must first be considered to be accurate before it can have an impact on financial markets.
Test 3
How soon in a particular month is this data release published? Financial markets are all
about finding out information sooner rather than later. So not surprisingly they pay most
attention to the indicators that are published first each month.
Let us apply this test to the US employment release

1. Policy impact. This is a key factor in US economic policy-making. Just look at any set of
Federal Open Market Committee minutes. You will see several references to the state
of the labour market in the United States. The employment data do have a significant
impact on the direction of the Fed’s interest rate policy.
50
We will score it 9 out of 10.

2. Reliability. These employment data are very reliable. Sure, they will get revised, but this
does not seriously undermine the initial release.
We score it 8 out of 10.
3. Relative timing. This is the first important economic release each month. 3
We score it a maximum 10 out of 10. This gives it a total score of 27 out of 30 making it
FINANCIAL MARKETS
the number 1 data release in the United States.
The influence of this release goes far wider as traders in all markets watch this release for
clues about the state of the world’s most important economy and the next move in the
Fed’s interest rate policy.
This Financial Times article reports on the latest employment situation report for May
2007 published on Friday 1 June 2007. It shows a surprisingly strong economic picture
with employers adding 157 000 jobs to their payrolls. This followed an 80 000 increase in
the previous month. The headline unemployment figure remained at 4.5 per cent. There
was further good news in the breakdown of the data with construction employment
holding steady, and employment in the services sectors such as banking and restaurants
remaining buoyant.
Economists were very upbeat after this release. The article reports one economist at the
Bank of America as saying ‘the resilience of the labour market will reassure policymakers
and market participants that job demand remains relatively healthy’. He goes on to
suggest that the resilience of the economy means that the Fed can stay focused on the
need to keep inflation under control.
Not surprisingly, the US equity markets reacted positively to the data. These strong
economic data are good news for equity prices as long as there are no signs that the
economy is overheating. The faster economic data will translate into more profits, more
dividends and higher share values. With little fear of the Fed raising interest rates, the
markets can just focus on the positive aspects of the employment report. However, it does
remove any prospect of an imminent cut in interest rates. The relatively high level of short-
term interest rates continues to attract funds into the US money markets which can explain
the dollar’s rise against the yen and the euro.
The only market to react negatively to the employment data was the US bond market.
The Financial Times reports that prices fell for the benchmark 10-year Treasury note with
the yield rising 5.3 basis points to 4.945 per cent. This is because the risk of higher infla-
tion caused investors to demand a higher rate of return on bonds. This applies especially
to long-term investors, as the uncertainty of their purchasing power is even greater.
I Key terms
Unemployment and non-farm payroll employment release This economic release is made
up of three parts. The first figure is the percentage rate of unemployment, which is based on a
random survey of people. The second part tells us the change in thousands each month in the
number of people on companies’ payrolls. It excludes various special categories such as farm
workers (hence the non-farm), the self-employed, unpaid family workers and the armed forces.
51
The final measure looks at the current trends in employee wage costs. It can provide early
evidence of any rising cost-push inflation.
Benchmark 10-year Treasury note The United States has the world’s largest government
bond market. The Treasury market is backed by the US government and as a result is seen as
having no default risk. It sets the standard for all other dollar denominated bonds. As a result
other dollar issues will see their yields set in relation to the equivalent US Treasury issue. The
market can be split into three divisions:
a. Treasury bills: This covers three months to 1-year maturity issues.
b. Treasury notes: This covers 2–10 year maturity and coupon bonds.
c. Treasury bonds: This covers bonds with a maturity of 10 years plus. The key long-term
bond is the 30-year benchmark issue.
Standard and Poor’s (S&P) The S&P composite index is based on the market movements of
500 companies that are listed on the New York Stock Exchange. This index is one of the most
widely used measures of US equity performance.
NASDAQ Composite This is a rival stock market exchange based in the United States. It is run
by the National Association of Securities Dealers and their automated quotation system gives us
the NASDAQ Index which began in 1971 with a value of 100. It now includes nearly 5000
companies with each one assigned to one of the eight sub-indices – banks, biotechnology, com-
puter, industrial, insurance, other finance, telecom and transportation. In general the NASDAQ
index is seen to focus on newer and emerging companies.
Dow Jones Industrial Average (DJIA) The DJIA is the main US stock market index. It is based
on the market movements of 30 of the largest blue-chip industrial companies that trade on the
New York Stock Exchange. The selection of these companies is revised regularly. It includes
companies like American Express, Boeing, Disney, General Electric, Honeywell, Intel, JP Morgan
Bank, Procter and Gamble.

1. Why does the US employment release have such a significant impact on financial markets?
2. What are the main features of the US employment report released on the first Friday
of each month?
3. The latest US employment data shows that economic activity is surprisingly sluggish in
the final quarter of the year. There is a sharp fall of 160 000 in employer payrolls com-
pared to an expected rise of some 50 000. In addition there were downward revisions
of 40 000 to the previous two months’ numbers.
Discuss the likely reaction to this data of:
a. the US stock market
b. the US dollar
c. US government Treasury bonds
d. US short-term interest rates.
52
You will need to look at the Financial Times on the first weekend edition in any month. Go
to the Markets section on the back page of Companies and Markets.
1. What impact did the latest US employment data release have on the world’s financial 3
markets?
FINANCIAL MARKETS
2. What was the impact on the three main US stock market indices?
Hint: Look at the World Markets data on the front page.
I Go to the web
Go the Bureau of Labor’s official website at www.bls.gov/ces.
a. Go to CES News Releases. Read the Employment Situation summary. Take some notes
for future reference.
b. You are now required to write a short essay on the latest report from the Bureau of
Labor. This should be approximately 300 words.
I Research
Vaitilingam, R. (2006) The Financial Times Guide To Using The Financial Pages, 5th edn, Harlow,
UK: FT Prentice Hall, Financial Times. You should especially look at Chapter 7 to get more infor-
mation on US stock market indices.
In addition www.bloomberg.com often gives excellent coverage of these economic releases.
53
Financial markets standing at a

crossroads
When you first start reading the Financial Times there is no doubt that one of the hardest
tasks is trying to understand the complex range of factors that cause major market move-
ments. It is similar to trying to find your way around a new capital city. At first the whole
process looks like a challenge that you will never master. However, with a little patience
you gradually get a feel for the place and you start to see the way the streets fit together.
In the same way the technical jargon associated with financial markets can be daunting.
But with practice it does get easier and you soon develop an understanding of what drives
the major movements in the world’s financial markets.
These articles were published at a crucial time. World markets were seen to be at a
crossroads. On the one hand there was a rising tide of bearish sentiment expressing the
view that interest rates were on a clear rising trend and that this would lead to a severe
correction in share prices. At the same time other analysts still remained very bullish. They
argued that the rise in interest rates would soon run out of steam and that the funda-
mental background remained positive for the stock market. The front-page story from the
Financial Times broadly sets out the prevailing bearish view while the Lex column argues
that for now the increase in bond yields was unlikely to cause any serious damage to world
markets.
Article 10 Financial Times, 8 June 2007 FT
Bond yields spark credit concerns

Michael Mackenzie, Richard Beales and Joanna Chung
The benign credit conditions that have ‘Stocks need to reflect what bond yields
helped fuel the global buyout boom are saying’, said Michael Kastner, portfolio
came under threat yesterday as the manager at Sterling Stamos. ‘Rate cuts
yield on 10-year US government bonds have been taken away and, if yields start
registered its biggest daily jump in to reflect that rate hikes are likely this
years. year, then it will get pretty ugly for stocks.’
Some analysts suggested the dramatic The yield on the 10-year US govern-
rise in yields could herald a sustained ment note hit 5.14 per cent in New York
period of higher interest rates, increasing trading, marking the biggest one-day
the cost of borrowing for companies, advance in several years, before settling
deflating borrower-friendly credit back to 5.10 per cent. That brought 10-
markets and eventually crimping the year yields above those on shorter-term
outlook for equity markets. Treasuries, restoring a more normal –
The S&P 500 index fell 1 per cent by that is, ‘steeper’ – yield curve.
midday in New York while the German For much of the past year and a half,
DAX dropped 1.4 per cent. longer-dated notes have offered lower
54
Article 11 Bond market sell-off
yields than shorter-duration bills, cre- could rise next month or in August.
ating a ‘conundrum’, as Alan Greenspan, Predictions of a Fed rate cut have largely
then chairman of the Federal Reserve, put been abandoned.
it in 2005. The sharp rise in the US 10-year bond
But yields on US, European and yield was particularly disturbing to tech-
Japanese government bonds have been nical analysts who monitor the pattern of 3
climbing for a month, fuelled by strong Treasury interest rates, which have been
FINANCIAL MARKETS
economic data and, in places, fear of infla- broadly on the decline since the late
tion. 1980s. Over this period, each peak in rates
Government bond yields soared yes- has been progressively lower. Yesterday’s
terday in the eurozone and the UK, advance created a higher peak, breaking
pushing the 10-year Bund yield to a four- the trend and potentially signalling a
and-half-year high and the 10-year gilt longer-term advance in rates.
yield to its highest for nine years. ‘A lot of people are scared of that 20-
The moves come a day after the year trend line and rightfully so’, said
European Central Bank raised its main Gerald Lucas, senior investment adviser
interest rate to 4 per cent. Many investors at Deutsche Bank. ‘A close above that
fear the ECB will continue raising rates level at the end of this week would likely
this year to counter inflationary press- target a further rise to 5.25 per cent.’
ures. The Bank of England yesterday kept The 10-year Treasury is widely used to
its main interest rate on hold at 5.5 per hedge risk associated with fixed income
cent, amid investor worries that rates securities.
Article 11 Financial Times, 8 June 2007 FT
Bond market sell-off

Lex column
The Treasury market has long acted as an rates during the past six months.
automatic stabiliser for the US economy. Meanwhile, credit investors who have
When the growth outlook looked poor, taken risky positions based on low
yields would fall, stimulating activity. The volatility and low yields in the Treasury
opposite would happen when growth market could get a shock.
prospects were strong. That did a lot of A lot depends on the reasons behind the
the Federal Reserve’s work for it. surge, which has taken 10-year yields
Meanwhile, bond yields were kept lower from 4.5 per cent to 5.08 per cent in two
than might have been expected by flows months, and how far it goes. Much of the
from overseas buyers. jump is down to a reassessment of US
Does the sudden run-up in yields now economic prospects. Fears of a housing
risk acting as an automatic destabiliser? meltdown have subsided, labour market
The obvious weak points are housing and statistics are still strong and manufac-
credit markets. Residential real estate turing data have improved. Investors have
remains weak and could be hit further by stopped factoring in interest rate cuts and
the half point rise in 15-year mortgage started betting on a stronger economy.
55
If the bond market stays weak, Meanwhile, strong global growth and
however, investors will worry that the rising international yields could pull US
international effects that have helped yields higher.
keep yields low are unwinding. There is For now, the change in yields is unlikely
already a fear that Asian central banks to cause too much pain. If they repeat
will diversify their huge foreign exchange their performance of the past two months,
holdings away from US Treasuries. however, it could really start to matter.
I The analysis
Article 10 suggests that a sharp rise in US government bond yields could signal the end of
a period when low interest rates have acted as a catalyst for booming stock markets world-
wide. The first signs of this unease were clear from the sharp fall in both the US S&P index
and the German DAX index. So what caused the rise in bond yields?
First, one major factor was stronger economic data. This rebound in economic activity
raised fears of a return to inflationary pressures both in the US and Europe. Bond markets
always take fright when faced by this combination of higher economic activity and rising
consumer prices. There were rises in yields right across the maturity spectrum. In the
shorter-dated bonds there were rises in yields reflecting the increase in short-term interest
rates in the US, the Eurozone and the UK. Remember short-term bonds must compete
with the money markets for the funds of investors. So if short-term interest rates increase,
so must the returns on shorter-dated bonds otherwise investors will not buy them.
As for longer-term bonds, yields also rose to protect investors against any threat of
rising inflation. Do not forget that most bonds are fixed-rate investments. So if inflation
rises it is only natural that investors will demand higher yields to maintain their real level
of return.
Take a simple example . . .
A US 10-year Government bond:

It has a nominal yield of 6.5%
With inflation at 2.5%
Real return ⫽ 4.0%
If inflation rises to 3.5% . . .
The nominal yield must rise to 7.5% to maintain the same real return.
A US 10-year Government bond:

It has a nominal yield of 7.5%
With inflation at 3.5%
Real return ⫽ 4.0%
One consequence of these movements in the US bond market was that the yield curve
returned to a more normal shape with long-term bond yields once again above those of
56
shorter-term Treasuries. This upward move in bond yields was matched in the Eurozone
and UK bond markets as investors reacted to increased interest rates from the European
Central Bank and the fear of another increase from the Bank of England soon. In addition
there was a clear realisation that there was no prospect of the Fed cutting interest rates in
the near future.
The role of the Lex column is to pick out the key financial stories each day and provide 3
a clear commentary putting some perspective on the short-term market reaction. It starts
FINANCIAL MARKETS
here by suggesting the bond market has been acting as a ‘stabiliser for the US economy’.
So, when the economy takes a downturn we see a fall in bond yields that acts as a stimu-
lant to economic activity; and when the economy picks up we see a rise in bond yields
which acts to suppress economic activity.
However, there is now a worry that this latest rise in bond yields could act to de-
stabilise the US economy. There are three main factors that have caused the surge in
10-year bond yields. First, the economic outlook in the United States has shown a marked
improvement. The labour market is strong, the housing market looks less vulnerable and
manufacturing activity is recovering. This all means that investors can no longer look to
the Fed to cut interest rates. A second factor that might explain the rise in bond yields
could be the foreign selling of US Treasuries as the Asian central banks start to diversify
their massive foreign exchange reserves into non-dollar currencies. As they sell US
Treasury bonds their yields must increase. Finally, there is the strength of the global
economy and the consequent rise in international yields which could pull US yields higher
as well.
At this stage the Lex writers appeared to be fairly relaxed. They see the small rise in
bonds yields so far as being ‘unlikely to cause too much pain’. However, there remains the
threat that any further spike in bond yields could signal a much more serious correction in
stock prices.
I Key terms
Benign credit conditions This simply refers to the cost of borrowing money. It might be a
government borrowing (in the government bond market), a company borrowing (in the cor-
porate bond market), a house owner (with a mortgage) or a consumer (with a credit card).
We have ‘benign credit conditions’ when the cost of borrowing is considered to be low by his-
toric standards. So low bond yields are seen as supporting the stock market. How does this
work?
Well, in the first place, if bond yields are low then investors will look to buy shares instead in
the search for a better return. Second, a low cost of borrowing will encourage a stronger level
of economic activity which will fuel demand for goods and services which leads to higher cor-
porate profits. This ultimately feeds through into higher dividend payments which are the key
to higher share prices. Finally, a low cost of borrowing will make it cheaper for companies to
borrow money, which will make investments more profitable.
German DAX index The DAX index is the most important German stock market index. It is
considered to be the standard benchmark for shares quoted on the Frankfurt Stock Exchange.
It started in 1984 with an initial value of 1000.
57
10-year bunds Bunds are simply German government bonds. These are used to fund the dif-
ference between Federal government spending and revenue. As normal the benchmark
long-term government bond is the 10-year maturity.
European Central Bank (ECB) and key interest rate The ECB is the Eurozone’s most
important financial institution. It is in control of a single monetary policy for all the countries
that have adopted the euro. The main policy objective of the ECB is to maintain price stability
in the medium term. This is defined as a 0–2 per cent target range for consumer price inflation.
The key part of the ECB is the Governing Council that meets every fortnight on a Thursday.
However, interest rate changes can only be made in the first meeting each month.
The key interest rate is the ECB’s repo rate. This is the main tool used by the ECB in providing
refinancing operations in the money markets. Under a repo operation commercial banks bid for
funds from the ECB at a fixed interest rate. The ECB will purchase various high-quality financial
market securities from theses banks to act as security for the loans. Then after a set period
(usually 14 days) the banks must repurchase their securities back from the ECB and pay interest
on the borrowed funds at the agreed repo rate.
Yield curve The yield curve is a graph that shows the relationship between interest rates or
yields and the level of maturity. You should see the key terms for Article 5 for a more detailed
discussion of yield curve shapes.
The relationship between bond yields and economic activity A key aspect of economic
activity is the borrowing and lending of money which causes a set of interest rates to be estab-
lished. Economic activity is a key influence on short-term interest rates which ranges from
overnight to one-year borrowing. In practice other economic factors tend to dominate in the
setting of the longer-term bond market yields.
Short-term loans are set by the demand from companies for loans and the rates of return they
think they can expect to earn on these funds.
In good times there are opportunities for high profits.

Companies borrow more money at high interest rates.
In bad times these opportunitites diminish.

Companies are less willing to borrow money at high interest rates.
The interest rates derived from economic activity tend to be very short term.
But most bonds are in practice much longer term. As a result a range of other factors
come into the picture when setting long-term interest rates. The key factor for long-term
interest rates is the rate of inflation. As inflation rises investors will demand a higher rate
of return on bonds. This especially applies to long-term investors as the uncertainty of
their purchasing power is greater. Inflation is very important in setting long-term bond
prices.
The level of a country’s fiscal deficit can also be of some relevance in setting longer-term bond
yields. A larger deficit will require higher yields to attract new investors. At some stage increased
borrowing can also impact on the level of credit risk. If a country is perceived as being a lower
credit risk, the level of its bond yields must rise to compensate for this higher risk. Argentina is
58
a good example of a country that has often had a bad credit rating because it has frequently
defaulted on its bond issues in the past.
To conclude, there is a very complex set of factors that determines the level of interest rates.
Most short-term interest rates and short-term bond yields are determined by the level of econ-
omic activity and the resulting activities of the central bank. In contrast, longer-term bond yields
are primarily set by the inflation outlook. 3
FINANCIAL MARKETS
1. Clearly define what is meant by the term ‘benign credit conditions’.
2. Why is there a strong link between the level of bond yields and the world’s stock markets?
3. What reasons does the Lex column article suggest can explain the ‘surge’ in US
Treasury yields?
You will need a copy of the Financial Times. Go to the front page of the main section and
look at the World Markets data on the bottom of the front page.
1. What is the current level of the S&P 500 index?
2. What is the current level of the Xetra Dax index?
3. What is the yield on 10-year US government bond yields?
4. What is the yield on 10-year German government bond yields?
I Go to the web
Go the ECB’s official website: www.ecb.int/home/html/index.en.html.
Find the current level of the ECB’s main refinancing operation minimum bid. Now go to
the section on monetary policy.
a. What are the main aims of monetary policy?
b. What are the benefits of price stability?
I Research
For a good understanding of what moves the financial markets on a daily basis there is no short-
cut. You need to read the Financial Times regularly, particularly after days when there have been
significant movements in the main financial markets. Read the articles regularly (look at the Lex
column as well) and you will soon get a feel for what drives the financial markets.

59
Topic 4
Debt finance
We should begin this topic by explaining what is meant by the term ‘debt’. This is
actually quite a straightforward concept as it simply represents something that must be
repaid in the future. It could be a favour that a friend has granted you in the expectation
that you will return the compliment in the years ahead. In financial markets we define
debt in relation to financial commitments that often stretch far ahead in the future.
These arrangements are formalised in terms of a bond which is a contract where the
holder lends money to another party in return for annual interest payments and the
eventual repayment of the loan. On almost any day a quick review of the Financial Times
will show that the international bond markets are a very important area in terms of their
impact on financial markets. You will see many examples of new bond issues from
companies, governments and a wide range of other large organisations. There are three
main definitions for these new bond issues:
1. Domestic bonds where the issuer launches a bond in its local currency and home
country. For example, a UK company might launch a new £500 m bond issue in
London.
2. Foreign bonds where an issuer goes to another country to issue a bond in a foreign
currency. For example, a German company might launch a new $500 m bond issue
in the United States. This type of foreign bond issue is called a ‘Yankee bond’.
3. Eurobonds where the issue takes place outside the country of the currency in which
the bond is denominated. For example, a German company might launch a new
$500 m bond issue in France. This type of bond is called a Eurobond because the
issue is in US dollars and it takes place outside of the United States. You should be
aware the term ‘Eurobond’ does not mean that the issue has to take place within the
European financial markets.
In the context of corporate finance, the term ‘debt finance’ refers to the money that a
business has to borrow in order to fund its various activities. In practice, we normally
divide this debt finance into short-term and long-term borrowing. We also differentiate
between the different degrees of risk attached to various types of corporate debt issues.
The main types are:
1. Secured debt (commonly known as a debenture). This is the highest grade of debt
issued by a company. The issuing company gives the debt holders a secured claim
on various assets that are owned by the business. So, if the company cannot meet
interest or redemption commitments, the holders are entitled to receive these assets
in exchange. The assets in question might be financial (various types of securities),
property or other physical goods owned by the company.
Debt finance
When this form of debt is secured on property assets it is called a mortgage debenture.
2. Senior unsecured debt. This comes next in terms of the debt capital hierarchy. In
the case of a company liquidation the holders have claim on the assets left after the
secured debt providers have been fully paid.
3. Subordinated or junior debt. The holders of these debt securities accept a lower
rank than the first two levels of debt in the case of a corporate default. In return,
they will be normally compensated in the form of higher interest to offset this
additional risk. In terms of risk they are often little better off than the preference
shareholders. The only providers of capital below them are the ordinary shareholders,
who always take the biggest financial loss if a company fails.
There are a number of other key terms associated with debt products that you should
understand before we start to analyse the articles in this section:
1. Fixed-income securities. You might see the debt markets referred to as fixed-income
securities. This is simply because most bonds carry a fixed interest rate (called the
coupon) and a fixed maturity date (called the redemption date). You should be aware
that, although this is the most common form of debt issue, there are many other
types with variable interest rates and redemption dates.
2. Convertible bonds. These are bonds issued by companies that give the holder the
right to exchange their debt market products for shares in the issuing company at
some stage in the future. We will learn more about them in the articles that follow.
3. Warrants. These are financial instruments that give the holder the right to purchase
financial market securities from the issuer at a set price within a certain time period.
They are commonly attached to certain new bond issues giving the holder the right
to buy some shares in the issuing company.
4. Zero-coupon bonds. These are bonds that do not have any interest payable but will
instead be offered at a significant discount to the par value. This results in a large
capital gain at redemption.
5. Commercial paper. This is a form of very short-term financing instrument used by
companies. The normal maturity of commercial paper is 270 days. They are usually
only made available to those companies with the best credit-rating.
6. Bond yield. When an individual or a company borrows money, there is a cost that
they have to pay in order to obtain the funds. If it is a short-term loan (up to one
year), this is normally referred to as an interest rate. So we might take out a one
month bank loan with an annual interest rate of say 8.5 per cent. This is the interest
rate, or the cost of obtaining the funds. If a company needs to borrow funds for a
longer time period, this will normally be through the issue of a bond market security,
which is usually repaid at a fixed rate of annual interest (this is called the coupon)
until it is finally repaid on the date that it redeems or matures. The yield on the bond
issue is the cost to the issuer or the return to the investor who buys the bond.
Every day there are many new bond issues from companies, governments and a wide
range of large organisations. The first article in this topic looks at the process of
62
Debt finance
launching a new bond issue. In the second and third articles we discuss some of the
more innovative products that now feature in the bond markets. The last article shows
how in the wake of the credit crunch bond investors were looking towards the premium
eurozone countries that offer greater security.

4
Article 12
DEBT FINANCE
Athens prepares 50-year bond issue worth €500 m–€1 bn
Article 13
Convertibles stage a return to fashion
Article 14
Record samurai deal by Citigroup
Article 15
Flight to liquidity pushes Eurozone bond yields apart

I different types of bonds defined;
I liquidity in bond markets;
I bond auctions;
I bond yield spreads and credit-rating;
I budget deficits;
I the convertible bond market;
I exotic products;
I book runners;
I arbitrage;
I liquid yield option notes;
I divergence in bond yields (European bond markets);
I sovereign entities.
63
Greek government launches new bond

issue
The international bond markets are an increasingly important area in terms of financial
market activity. Every day we see many new bond issues from companies, governments
and a wide range of large organisations. This article examines the process of a government
looking to issue a very long-term debt security. It shows clearly the relationship between
a countries’ credit-rating and the expected yield on the new bond issue.
Article 12 Financial Times, 18 January 2007 FT
Athens prepares 50-year bond issue worth

€500 m–€1 bn
Kerin Hope
Greece is planning to issue a 50-year bond While Greece’s credit rating is still the
in the first half of this year to take advan- lowest in the eurozone, Moody’s last week
tage of strong liquidity in international changed the outlook on its single A rating
markets and a flat yield curve, Petros from ‘stable’ to ‘positive’, indicating an
Doukas, the deputy finance minister, said upgrade may be on the way. Market-
yesterday. watchers said they expected the 50-year
Mr Doukas put the size of the issue at issue to take place at the end of the first
€500 m–€1 bn. The funds would be quarter or beginning of the second. It would
raised through an auction process rather follow 15- and 30-year issues that are
than a syndication. Greece has already already planned under this year’s €33.5 bn
received several offers from banks to borrowing programme. ‘It’s prudent for an
make private placements for a 50-year issuer to borrow at the long end, and there’s
bond. definitely appetite in the market for a Greek
‘With the yield curve flat, the cost of the bond of this tenor’, said George Kofinakos,
50-year bond will not be above that of 30- managing director of Citigroup Greece.
year paper’, Mr Doukas said. Greece is Greek prospects are picking up, with
already popular with the market as the GDP growth this year projected at about
eurozone’s high-yield borrower, with 4 per cent for the fifth successive year.
spreads of 30–35 basis points above the The country is poised to emerge from
bund on its 30-year paper. Greece, which the European Union’s excessive budget
would be following in the footsteps of France deficit procedure, after reducing the 2006
and the UK last year, would be the smallest deficit below the 3 per cent of GDP euro-
country to date to launch a 50-year bond. zone ceiling.
The analysis
In this article the focus is on a prospective new international bond issue from Greece which
was planning to launch a 50-year bond in the first half of 2007. The move was announced
64
Article 12 Athens prepares 50-year bond issue worth €500 m–€1 bn
by their deputy finance minister Petros Doukas. The new bond issue was timed to take
advantage of strong liquidity in financial markets and the presence of a relatively flat yield
curve. Greater liquidity in financial markets suggests that there would be plenty of demand
for a new large bond issue. Also, the flat yield curve suggests that the costs of issuing a
longer-dated bond would be relatively cheap compared to shorter-term maturities. The
article quotes Mr Doukas as saying ‘the cost of the 50-year bond will not be above that of 4
a 30-year paper’. We would normally expect to see an upward-sloping yield curve where
DEBT FINANCE
longer-term bond yields would be significantly higher than short-term bond yields.
In the context of the European government bond market, Greece stands out as the
market with the highest level of yields among the Eurozone economies. Their bonds have
a positive yield spread of some 30–35 basis points above the equivalent German 30-year
bonds. This reflects the fact that Greece’s credit rating is the lowest in the Eurozone. One
rating agency, Moody’s, rated Greece’s credit risk at a single A with the outlook recently
upgraded from stable to positive. Against the background of a favourable economic
outlook, the article concludes with a glowing assessment from the managing director of
Citigroup Greece. Economic growth is expected to hit an annual rate of 4 per cent for the
fifth successive year and the budget deficit has been reduced to below the European
Union’s ceiling of 3 per cent of GDP.
I Key terms
Flat yield curve A flat yield curve shows the level of yields being broadly similar across the
maturity spectrum. (See Article 5 for a detailed explanation of yield curves.)
Liquidity In financial markets this normally refers to how easily an asset can be converted into
cash. Therefore, notes and coins are the most liquid financial asset. In general, the more liquid
an asset, the lower is its return. In this article it is used to indicate there is a great deal of cash
available to invest in new government bonds.
Bond auction process Most new government bond issues are sold through a system of
auctions. Normally the country’s Treasury is in charge of new issues. It will give an early warning
of the maturity of the issue, and then a week or so before it will firm up details of the size of the
issue, the total amount being raised, the maturity and the bond’s annual coupon.
This very simple example might show how the bidding works
A government invites bids for a new bond auction. The new issue is a £3 bn 6 per
cent bond issue due to mature in 2035.
The following bids come in: Price bid How much accepted?
£100 m at £98.65 100% = £100 m
£125 m at £98.60 100% = £125 m
£135 m at £98.50 100% = £135 m
£140 m at £98.45 100% = £140 m
£160 m at £98.40 100% = £160 m
65
£2200 m at £98.35 100% = £2200 m

£1400 m at £98.30 10% = £140 m
This gets us to the £3 bn available.

Any bids below £98.30 will be rejected. This is a competitive bidding process so
you pay the price you bid if it is accepted.
Bond yield spreads This refers to the yield on a particular bond issue minus the yield on the
nearest comparable government bond issue. So in this case we are comparing 30-year bonds
from Greece with those from Germany (bunds).
German 30-year bunds yield ⫽ 4.17%
The spread equals ⫹30–35 basis points
So the Greek 30-year bond yield ⫽ 4.47–52%
Note: 100 basis points ⫽ an extra 1 percentage point on the yield.

50 basis points ⫽ an extra 0.5 percentage point on the yield, etc.
The spread is determined by a combination of the bond’s credit rating, liquidity and
the market’s perception of its risk relative to the other bond.
Bond credit rating Most new bond issuers are assigned credit ratings by the various
companies that are involved in this activity. They include Standard and Poor’s and Moody’s. The
highest credit rating allocated by Moody’s is a triple A. For example, this is awarded to the
German government’s bond issues. In this article we learn that Greece has a rating of a single
A. And this is under review with a ‘positive’ outlook favoured.
Short summary of Moody’s credit ratings
AAA ⫽ Capacity to pay interest and principal extremely strong

AA ⫽ Differs only in a small degree
A ⫽ More susceptible to adverse changes in circumstances
BBB ⫽ Adequate capacity
BB, B ⫽ Speculative
C ⫽ No interest being paid
D ⫽ In default
Budget deficit A country’s budget deficit refers to the difference between its spending and its
revenue. It is normal for any government to spend more money on health services, education,
defence, etc. than it can raise revenue from income taxes, sales taxes, etc. The result is a fiscal
deficit or a budget deficit. We normally like to compare a country’s budget deficit by expressing
it as a percentage of the country’s gross domestic product or income.
66
This would be just the same for an individual. It is fine for a Premiership footballer with an
income of £5 m per year to run a deficit of £1000 in a particular year. This amounts to a tiny
percentage of his annual income. So he can repay this debt very easily in the next year. It is
quite another matter for a student running up a deficit of £1000 in a particular year when her
income is only £5000 per year. Her deficit is 20 per cent of her annual income and it will be
much harder for her to repay this debt until her income rises significantly when she lands that 4
lucrative job with an investment bank after graduation!
DEBT FINANCE
1. What are the main factors that will determine the sovereign risk on a new international
bond issue?
Hint: Sovereign refers to the risk of a particular country.
2. Are the following bonds:
Eurobonds (E)
Foreign Bonds (F)
Domestic Bonds (D)?
(i) The Swiss government issues a euro-denominated bond in Germany.
(ii) Microsoft issues a US dollar bond in the United States.
(iii) Deutsche Telecom issues a yen bond in Japan.
(iv) The French government issues a Swiss franc bond in London.
(v) The World Bank (based in New York) issues a euro-denominated bond in Paris.
3. Why is the Greek deputy finance minister expecting to be able to issue this new long-
term bond issue at a particularly low cost at the time of the article? What are the
potential financial market risks that could result in a much higher yield on this new
bond issue in reality?
4. What are the advantages for Greece in raising these funds through a bond auction
compared to a placement process?
5. There is a very positive view on the prospects of the Greek economy expressed here by
the managing director of a large investment bank’s Greek office. Why should we read
these comments with a degree of caution?
6. Undertake some research and set out a balanced view of the current prospects for the
Greek economy.
Data section and look at the bottom left-hand side of the page. In this section you will see
a section called Benchmark Government Bonds.
67

1. What is the current level of 30-year bond yields for Germany?
2. What were they a year ago?
3. By looking at the four US government bond issues describe the current shape of the
US bond yield curve.
4. Which country has the highest 10-year bond yield?
5. What has happened to the level of 10-year Greek government bond yields in the last
day, week, month and year?
Now look to the right of this column and examine the High-Yield and Emerging Market
Bonds section.
1. Choose any four bonds in the emerging US$ section. Discuss the link between their
spreads versus US Treasuries (see the last column) and their credit-rating.
2. In the high-yield €section which bond has the largest spread compared to US Treasuries?
I Go to the web
Go to the official website of the Financial Times: www.ft.com.
Go to the Markets section and select Market Data from the drop-down menu.
Go to the Bond and Rates section. Select FT Bonds Tables.
On the drop-down menu select the International Bond Issues section. You will be able to
access details of recent new international bond issues.
a. Find a recent example of a new bond issue from a sovereign nation.
b. Compare the yield on this bond to a bond issue from a more risky corporate issuer in
the same currency and with a similar maturity.
c. Calculate the yield spread between these two issues.
d. Explain the rationale for the size of this spread.
e. Which large international banks tend to be the bookrunners on most of the new issues?
I Research
Arnold, G. (2008) Corporate Financial Management, 4th edn, Harlow, UK: Prentice Hall Financial
Times. You should especially look at Chapter 11, pp. 449–56 to get more information about
international bond issues.
The topic of corporate bonds is covered in Chapter 8. You should look at pp. 228–33.
Edition. There is a US-based introduction to the corporate bonds in Chapter 6 on pp. 291–8.
Financial Times. There is an introduction to loan notes and debentures in Chapter 8.
68
Pilbeam, K. (2006) International Finance, 3rd edn, Basingstoke: Palgrave Macmillan. Chapter 12
provides a very good overview of the Eurobond market. The main features of Eurobonds are set
out on pp. 315–16.
Macmillan. You should look at Chapter 6, especially pp. 137–53. This provides a good general
introduction to bond markets. 4
DEBT FINANCE
Prentice Hall Financial Times. You should look at Chapter 5, especially pp. 126–28.
69
Japanese convertibles back in fashion

The fundamental financial market products are shares, bonds, foreign exchange and also
cash traded in the money markets. However, over time the banks have created a range of
more complex products with each one designed for a specific purpose. One new type of
bond might reduce the debt issue costs for a particular company. Others might have a tax
advantage for the issuer, at least until the tax authorities clamp down on this practice.
This article examines one of the first innovative financial market products to be created.
These are convertible bonds which are a delightfully simple instrument. A convertible is a
debt issue that allows the holder to convert the bond into shares in the issuing company
at a set price at some stage in the future. This article looks at the strong rebound in the
convertible bond market in Japan during 2006.
Convertibles stage a return to fashion

David Turner
A couple of years ago, Japan’s convertible Because of low volatility in 2005 ‘the
bond market looked on the brink of condition of the market was terrible’,
extinction. Annual issuance by Japanese says Takashi Masuda, a senior official in
companies was running at just $2.7 bn – the syndicate department of Nomura,
less than a sixth of the level of issuance Japan’s biggest book runner of convert-
in 2004 and the lowest amount since ibles last year in both value and number
1998. of deals. Some investment banking
But in recent months, the sector has departments responded pessimistically by
started to make a spectacular return, trimming the number of convertibles
spurred by higher share-price volatility, staff in Japan.
the hunger of hedge funds and a contin- Among bankers there were fears this
uing stream of new and exotic products. was more than a mere temporary blip
Last year total issuance bounced back caused by market conditions. In par-
to $12.6 bn through more than 50 deals. ticular, they feared structural changes
Investment bankers say it could be even might be afoot – most notably because
higher this year if share prices remain Japanese companies are increasingly
volatile. scared of hostile takeovers and afraid con-
The biggest reason why convertible vertibles could be used a weapon to storm
issuance has risen so fast is exactly the the ramparts.
same reason why it fell so far in 2005: The wary could point to the example of
share price volatility. This allows issuers Sumitomo Warehouse. In 2005 activist
to gain a good price for their convertibles shareholder Yoshiaki Murakami became
on the grounds there is a strong chance the leading shareholder in the company
that the underlying shares will reach the by using convertibles.
price at which investors can convert the But other investment bankers thought
bonds into equity. these fears of a permanent souring
70
Article 13 Convertibles stage a return to fashion
against convertibles were excessively pes- The range of styles of convertible that
simistic. And these days the optimists are is being offered in Japan is mind-boggling
starting to look right. and is used by different underwriters to
Higher volatility was not the only jockey for competitive position. This
blessing that restored the market. Gareth creates a relentless quest for further inno-
Lake, managing director of equity capital vation to find something new for Japan to 4
markets at Nikko Citigroup, one of offer issuers, though Japanese issuers are
DEBT FINANCE
Japan’s biggest convertible book runners, reluctant to experiment with outright
says ‘the dearth of issuance’ in 2005 ‘firsts’ for the world. This innovation
encouraged funds to start ‘looking for new cycle means, according to Mr Woodthorpe,
paper’. The biggest investors are the that ‘whatever you did yesterday becomes
global convertible arbitrage hedge funds, plain vanilla today’.
which often follow a strategy of buying an But one factor that could help the
issuer’s convertible bonds while shorting market even more than innovation is
its shares (or betting that its share price something more prosaic: regulation. One
will fall). Japanese pension funds have investment banker who arranges the
also shown interest. small and mid-size convertible deals sold
The market has been further boosted into the domestic rather than inter-
by the spectre of rate rises from the Bank national market says issuance is
of Japan. The bank has lifted rates only hampered by the seven-day rule that
once in the current cycle, back in July, but applies to all deals sold to retail investors.
is expected to start raising them again After announcing a convertible issue,
soon – albeit rather slowly. issuers have to wait a week before setting
Alex Woodthorpe, Tokyo-based the conversion price. But in the week that
chairman of Pacific Rim equity capital has elapsed, the share price may have fallen
markets at Merrill Lynch, says: ‘The sharply, leaving issuers with a much lower
ability to fund at zero coupon ahead of conversion price than they first expected.
the interest rate curve is appealing to
issuers’. Japanese equities
For those investors reluctant to buy Nikkei 225 Average (’000)
zero-rate products because they think the 40
bank may raise rates more rapidly than 35
the market expects, there is a solution: 30
liquid yield option notes, or ‘lyons’. 25
These are convertibles that are issued 20
at sub-par, thus generating a yield despite 15
10
the zero coupon. Merrill Lynch arranged
0
Japan’s first ever lyon, a 1.022 bn deal for 1990 92 94 96 98 2000 02 04 06
leasing company Orix, in 2002. Source: Thomson Datastream
The analysis
2006 saw the Japanese convertible bond market very much back in favour with 50
new corporate issues raising over $12.5 bn. This article looks at the main reasons
behind this strong rebound in the market. It argues that it was due to three principal
factors.
71
1. Higher share price volatility. This was the single most important factor. When
investors buy a convertible they have the right to convert their bond into shares in the
issuing company at a set price which is set at a premium to the current market share
price.
We can work this out from the conversion ratio which is the number of shares into
which a convertible bond can be converted. For example, if the conversion ratio is 40
then an investor will be able to convert every $100 nominal value of the bond issue
into 40 shares in the issuing company. This would mean that the conversion price
would be $2.50 ($100/40). This conversion price is normally set at a premium to the
company’s current market share price. So in this case the market price might be $2.00,
which means that the conversion premium is 25 per cent.
2.50 – 2.00
⫽ 0.25 or 25%.
2.00
A final important term associated with a convertible bond is the conversion value of
the bond. This is the value of the bond assuming it was converted into shares at the
current market share price.
In this case the conversion value of the bond would be $2.00 ⫻ 40 ⫽ $80.
A company clearly wants to be sure that the bond will convert into equity finance
which will only happen when the share price at least rises to the conversion price level.
When share prices are static or, even worse, falling, any conversion is much less likely.
This brings the potential risk to the issuing company that they might have to redeem
a bond which they had assumed would convert into equity finance. So, we need to see
rising share prices to encourage issuers to launch new convertible bonds and for
investors to be willing to buy them.
2. Demand from hedge funds. Hedge funds have become big players in the fund man-
agement industry. The Financial Times reported that they were using complex arbitrage
operations that involved buying a company’s convertible bond and at the same time
shorting (selling) its shares. It seems that the hedge funds’ traders had identified a price
anomaly in the market which created this opportunity for them to make profits
through these arbitrage trades.
3. An ever-growing stream of new innovative products. We have also seen the clever
‘financial engineers’ employed by the investment banks designing new and innovative
products. One such instrument is the ‘liquid yield option note’ (lyon). The Financial
Times article provides a clear description of them. ‘These are convertibles that are
issued at sub-par thus generating a yield despite the zero coupon.’ Put simply, this
means that you buy the bond at a discount to its redemption price so that the resulting
capital gain compensates for the lack of any coupons. The great attraction of these
new products is that they were issued at a time when Japanese money-market interest
rates were at last starting to increase. With these new products companies have been
able to issue their zero coupon bonds to meet their funding requirements before any
sharp increase in bond yields which would inevitably follow the tightening in Japanese
monetary policy.
72
The article ends by claiming that a final boost to the market would come from reduced
regulation. There is one particular rule that investment bankers argue has held back this
market. This is the so called ‘seven day rule’, which means that a convertible issuer has to
wait seven days before setting the conversion price. It represents a significant risk for the
issuer since if the share price falls during this period the final conversion price might be
much lower than expected. 4
I Key terms
DEBT FINANCE
Convertible bond These are bonds which provide the holders with the right to convert their
bonds into shares in the issuing company. This conversion option will be at an agreed price at
a set date in the future. Initially this will not be a worthwhile transaction as the conversion share
price will be set well above the current market share price. However, as the market share price
rises in value over time, so the conversion will soon be a valuable option for the bond holder.
Convertibles are a classic debt equity hybrid product. One way to explain their attraction is to
compare them to swimming in the sea. Most people would love to dive straight into a warm ocean
for a relaxing swim. However, if they are told that there are sometimes sharks around in the sea
they will become much more cautious. So, instead, they may prefer to paddle in the breaking
waves until they feel more confident that the risk of sharks is over. Only then will they be willing to
swim further out into the ocean. In the same way buying convertible bonds is a way for risk-averse
investors to start with a relatively safe bond investment. Then when they feel more confident about
the prospects for the company, they can convert the bonds into the more risky shares.
Hedge funds This refers to a particular type of investment management where the fund
manager will employ a range of different investment tools in an attempt to maximise the
returns or try to make gains even in a falling market.
Exotic products This is a term to cover new innovative financial markets products. The use of
the term ‘exotic’ denotes that these are different to the normal version of this product. You will
see it used in several contexts such as exotic bonds, exotic swaps, exotic options, etc.
Book runner This is the lead manager who is in charge of the whole process in a new bond
issue. They will be jointly responsible with the issuer for inviting other banks to work on the new
issue in activities such as syndication and underwriting.
Arbitrage This is a very common practice amongst financial market traders. They will simul-
taneously sell (or buy) a financial instrument (for example a share or a bond) and at the same
time take an equal and opposite position in a similar instrument. This transaction will give them
a financial profit. This is possible where there is a clear price anomaly that has been identified
between the markets involved. In theory such arbitrage trading is considered risk free. This
makes it particularly attractive.
Shorting its shares This is used to refer to traders who sell a financial market security that they
do not yet own. In other words, they have not yet made an offsetting purchase. This is a very
risky activity since, if the price of the financial market security rises, the trader will have to pay
an ever higher price to secure the stock.
The reverse process is when a trader goes long. This means that they have bought some
financial market securities which they have not yet sold.
73
Liquid yield option notes (lyons) These are defined well in the article. They are zero-coupon
bonds that are issued below their par value. This guarantees the holder a return despite the zero
coupon.
Plain vanilla This denotes the simplest version of any type of financial market instrument. It
alludes to ice cream varieties. A plain vanilla ice cream is the simplest type you can buy. It has
no chocolate flake or any sauces!
Apparently the same term is used for DVDs. So a vanilla DVD is one that has no extras such
as commentaries or special features. I have to thank Mark Kermode (Radio 5’s film critic) for that
information!

1. What are the advantages for companies in issuing convertible bonds?
2. What factors determine the correct level of the premium between the conversion share
price and the current market share price?
3. What financial market conditions are necessary to ensure that a new convertible bond
issue will be converted in good time?
4. Explain what is meant when a trader is described as engaging in ‘short selling’.
5. What is meant by a plain vanilla financial market security?
I Research
should especially look at Chapter 11. There is a superb section on convertible bonds from
pp. 441 to 443.
The topic of convertibles is covered in Chapter 24 (see p. 794).
Edition. There is an excellent section on convertibles on pp. 732–7.
Financial Times. There is a useful introduction to convertibles on p. 240.
Hall. You should look at Chapter 5, pp. 128–36 to see convertible bonds well explained.
Pilbeam, K. (2006) International Finance, 3rd edn, Basingstoke: Palgrave Macmillan. Chapter 12
has a brief section on convertible bonds on p. 316.
74
Bulldog, Yankee and samurai bonds . . .

When you start reading the Financial Times, you might come across a term that will both
intrigue and confuse you. In this article there is a classic example with the discussion of
‘samurai bonds’. It might make you wonder what possible link can there be between 4
medieval Japanese warriors and the modern world of international finance. The answer is
DEBT FINANCE
simple. A samurai bond is the term given to identify a Japanese foreign bond. Other
foreign bonds have been given equally unusual names. So we also have bulldogs (sterling
foreign bonds), Yankees (dollar foreign bonds) and matildas (Australian dollar foreign
bonds). Once you know what they are, the rest of this article is much easier to understand.
Article 14 Financial Times, 6 September 2005 FT
Record samurai deal by Citigroup

Mariko Sanchanta
Citigroup, the world’s largest financial Japan’s benchmark 10-year govern-

institution, yesterday sold ¥230 bn in ment bond yielded an average of 1.37 per
samurai bonds, marking the largest such cent in the past year, sending institutions
issuance ever. and individuals searching for investments
The figure surpasses the record-high with better returns. In comparison, the
¥220 bn in samurais issued in 2000 by coupon on Citigroup’s 10-year samurai
DaimlerChrysler. Samurai bonds are yen- bond is 1.58 per cent.
denominated bonds issued in Japan by Nikko Citigroup, a joint venture of
foreign governments and companies. Nikko Cordial and Citigroup, lead
Citigroup sold six tranches of samurais managed the sale.
with maturities ranging from five to 30 Citigroup Japan said the Japanese
years. The issuance of 30-year samurai market remained ‘very important’ to the
bonds is also the first in the market, indi- US financial services giant, and it would
cating demand is growing for longer-dated continue to expand its presence in the
maturities. Citigroup Japan said it had market.
not yet decided how to use the proceeds Citigroup last year was ordered by
from the samurai issuance. Japan’s financial regulator to shut its
‘We’ve seen a pick-up from financial private banking operations in Japan for
institutions offering samurais’, said breaking banking laws. Its Japanese
Jason Rogers, banks analyst at Barclays private banking business will close by the
Capital in Tokyo. ‘It highlights the end of this month.
strong demand for samurais, which is
due to low interest rates and tight credit
spreads.’
75
Article 14 Record samurai deal by Citigroup
I The analysis
The US banking giant, Citigroup, has just sold the largest ever issue of samurai bonds.
These Japanese foreign bonds are yen-denominated bonds issued by non-Japanese
companies but sold primarily to Japanese investors. The dual incentive for Citigroup to
make such an issue comes in part from the low level of Japanese interest rates right across
all maturities, but the article also points to the presence of ‘tight credit spreads’. This
means that the cost of issuing higher risk bonds has fallen to very low levels. As a result,
they were able to sell a huge amount of bonds at a low cost of finance.
At the same time demand would have been strong from a wide range of Japanese
investors, including banks, insurance companies and pension funds. These firms were
awash with spare investment cash and a samurai bond enables them to obtain some diver-
sification in their bond portfolio with this international exposure. However, at the same
time they have none of the currency risk that would apply if they simply purchased bonds
issued in other countries.
The article explains that this new issue will be split into six tranches with some issues,
for the first time, having a very long-term maturity of up to 30 years. This issue confirmed
that Citigroup would be likely to expand their activities in the Japanese financial services
market.
The Financial Times reports that Citigroup has so far had mixed fortunes in the Japanese
finance sector. Back in 2004 the Japanese financial services authorities forced it to shut all
its private banking operations ‘for breaking banking laws’. It is expected that its Japanese
private banking business would be closed by the end of September.
I Key terms
Bonds A bond is a security issued by a government or a corporation which represents a debt
that must be repaid normally at a set date in the future. Most bonds pay a set interest rate each
year.
Foreign bonds are bonds issued by a foreign borrower in another country’s domestic market.
For example, we might have yen-denominated bonds issued by a foreign borrower in the
domestic Japanese market. They are called samurai bonds.
These foreign bonds are often given strange names:
Name Country
Samurai Japan
Yankee United States
Bulldog United Kingdom
Matildas Australia
Tight credit spreads This is a measure of the relative cost of issuing more risky bonds. It is best
seen with an example:
76
Let us assume that the United States government has close to zero risk of default. As
a result a 10-year US Treasury bond might have a yield of 4.5 per cent.
In contrast a 10-year issue from Ford Motor Company which has significantly more
risk of default might have a yield of 6.5 per cent.
This gives us a credit yield spread of 6.5 per cent minus 4.5 per cent ⫽ 200 basis 4
points difference.
DEBT FINANCE
If investors now start to buy lots of the higher yielding (more risky) bonds, this
could result in ‘tighter credit spreads’ as the relative cost of these bonds falls.
In this case the yield on the 10-year issue from Ford might fall back to 5.5 per cent.
This would reduce the yield spread to just 100 basis points. This would be a ‘tighter
credit spread’.
In this article this term is used to explain why there had been a spate of new samurai bonds.
The relative cost of issuing more risky bonds in yen-denominated markets had fallen sharply. In
this case Japan’s benchmark, 10-year government bond yield had fallen to an average of 1.37
per cent in the past year. This had forced Japanese investors to look elsewhere for better returns.
For example, the coupon on the new Citigroup issue was 1.58 per cent which was more attract-
ive to investors but also shows the impact of ‘tight credit spreads’ in terms of reducing the cost
of the bond finance for Citigroup.
Tranches This term is derived from the French word ‘tranche’ which means a slice. In this
context a tranche simply refers to the individual parts of a new bond issue. You might also see
the terms ‘tap’ or ‘mini-taplet’ used.
Private banking This refers to banks that manage the financial affairs for ‘high net worth’ individuals.
Banks analyst This is the person employed at an investment bank (in this case Barclays Capital)
whose job it is to advise the bank’s clients on the major financial institutions operating within
the financial services industry. They will be required to value these businesses and offer compari-
sons between their own and the market’s valuations as reflected in the current share prices.

1. Explain what is meant by the term a ‘samurai’ bond.
2. Why might a Japanese investor prefer to buy a samurai bond rather than a simple
domestic bond issue?
3. Why might a foreign company prefer to issue a samurai bond rather than a simple
domestic bond issue?
You will need a copy of the Companies and Markets section of the Financial Times. Go to
the Market Data section.
Hint: This is normally one page before the London Share Price Service.
77
Locate the Global Investment Grade section. Look at this table and select any five major
corporate bond issues.
1. You should calculate the spread on these bond issues compared to the benchmark
government bond.
2. Comment on the reasons for this additional yield.
Hint: Focus on the credit rating of the bond issuer.
I Research
should especially look at Chapter 11.
The topic of Eurobonds (including samurai bonds) is on p. 784.
Edition. There is a short introduction to Eurobonds on p. 297.
Financial Times. The definition of a Eurobond issue is on p. 239.
Hall. You should look at Chapter 16, p. 442 for a brief introduction to foreign bonds.
Pilbeam, K. (2006) International Finance, 3rd edn, Baringstoke: Palgrave Macmillan. There is a
good introduction to foreign bonds on p. 314.
Macmillan. You should look at Chapter 6.
FT Prentice Hall. You should look at Chapter 5 (pp. 127–8).
78
European bond markets start to diverge

There are some advantages of watching the financial markets from a safe distance these
days. Sometimes I feel that I am able to see things more clearly now than when I was right
in the heat of the action. I used to spend all my working day staring at the various news 4
screens struggling to find anything original to say to my Head of Trading and Head of Sales
DEBT FINANCE
who were the key players in the bond market-making desk that I serviced as an economist
for some four years. Ironically these days being far removed from the action I feel that I
am able to gain a much clearer insight into the financial markets than ever before.
It was like that with European government bonds prior to the introduction of the euro
in 1999. At that time I was mainly occupied teaching Economics to new classes of invest-
ment bank graduates. I can clearly remember thinking that there was a tremendous
trading opportunity available. Surely if all these markets would soon be denominated in
the same currency, there could not possibly be any justification for the continued level of
divergence between their government bond yields. So, a financial killing could be made
by buying the high-risk bonds (Italy, Greece and Spain) and selling the less risky bond
markets (Germany and France). Then, as the markets converged, there would be sizeable
profits for the bond market traders. Sadly, as good as this idea was I never acted on it. I
am probably too cautious by nature!
Flight to liquidity pushes Eurozone bond

yields apart
Joanna Chung
For almost a decade, yields on bonds France and Spain are being shunned –
issued by different governments in the relatively speaking – by investors.
eurozone have moved closer together. For example, the risk premium of 10-
Investors who bet on the story of con- year Italian government bonds has risen
tinued convergence profited handsomely. 12 basis points to 43 bp over comparable
But that trend has reversed in recent German Bunds since the beginning of the
months. As the credit global crisis year, while that of 10-year Greek govern-
gathered in intensity last year, yields ment bonds rose 14 bp to 44.5 bp over
started to diverge. Investors became more Bunds. Meanwhile, the spread of Spanish
selective, and started demanding higher 10-year bonds over Bunds has added 8bp
rates for some government debt. during the same period.
Now, spreads diverge more widely than The phenomenon highlights the degree
they have done since the creation of the to which the global credit turmoil is
euro nearly a decade ago, with Germany causing strains in markets that are trad-
at the top of the pecking order and Italy itionally seen as safe, and raises questions
and Greece at the bottom. Even bonds over how long spreads will continue to
issued by AAA-rated countries such as widen.
79
Article 15 Flight to liquidity pushes eurozone bond yields apart
‘The unfolding credit crunch is a cata- ‘The high volatility and uncertainty in
lyst, but spreads between Europe’s the market is prompting investors to
sovereigns [have been] set to widen for cover their exposures’, says one French
the past few years’, says Louis-Vincent debt management official. ‘The Bund
Gave, who runs GaveKal, a money man- futures contract is the most liquid debt
agement and research firm based in Hong instrument in Europe and that is causing
Kong. a natural demand for Bunds on the cash
‘Why should Italy borrow at the same side.’
rate as Germany. Why should Greece The so-called liquidity premium has
borrow at the same rate as Ireland? That become just as important as credit risk
shouldn’t happen.’ In other words, he premium in setting the spread between
says, investors should be demanding the most popular and least popular
higher premiums for bonds from govern- European government bonds.
ments that are seen as fiscally lax, such as ‘It is more a liquidity story than a credit
Italy and Greece. story’, says Erik Wilders, head of the
Mr Gave says one reason why rates con- Dutch State Treasury Agency. ‘Germany
verged in recent years was the fairly is the biggest and most liquid market, and
indiscriminate buying of Eurozone gov- that is what investors want right now.’
ernment debt by central banks and other Meanwhile, some countries, including
sovereign entities in Asia and elsewhere Belgium and Italy, have suffered political
as they rebalanced their reserves away uncertainty, while other specific factors,
from dollars. such as housing market worries in Spain,
Now these governments have indicated have also affected sentiment for par-
that they have enough bonds and are ticular bonds.
looking at other investment targets, in But Stan Malek, analyst at Bank of
part through sovereign wealth funds, he America, says ‘there is no reason why
says. So the fundamental differences countries like Austria should trade 10 bp
among eurozone issuers have begun to over Germany or why Belgium should
reassert themselves. trade about 20 bp over Germany’.
Together with Corriente Capital, which ‘We are in a very, very risk-averse
reaped millions from correctly calling the mode’, he says. ‘The consensus belief is
fallout in the US subprime market, that spreads will stay elevated for some
GaveKal launched its European time but if there is a positive event for
Divergence Fund in November. The fund, bonds, like a rate cut, yields could con-
which closed to new investors after verge again.’
raising $450 m, rose 20 per cent between Ciaran O’Hagan, head of Paris fixed
November and end January, says Mr income strategy, at Société Générale, says:
Gave, who expects divergence in the euro- ‘Many investors are asking if Italy and
zone to continue. Greece are seriously sick, or if the recent
But the causes of the divergence are asset price moves are just driven by global
many, experts say. One reason for the risk aversion.’
spread widening is the existence of a ‘The answer for us is firmly the latter
liquid futures market in Germany, which . . . both Greece and Italy will be around in
traders use to hedge investments and 30 years’ time and will probably be much
which has created a natural demand for more prosperous than what is reflected in
German Bunds over other eurozone debt, today’s repricing of sovereign risk.’
particularly during recent months of But movements in credit default swaps
market uncertainty. markets indicate investors’ perception of
80
risk is rising. For example, the five-year Sean Maloney, strategist at Nomura
CDS on Greek sovereign debt has risen International.
28.8 per cent to 56.7 basis points in the Mr Wilders of the DSTA says: ‘It took a
past month, according to Markit prices. while for spreads to converge after the
That means it costs investors €560,700 euro was launched, and it might take a
annually to protect €10 m worth of debt few years for them to reconverge because 4
against default over a five-year period. a lot of people got burnt in the last few
DEBT FINANCE
‘It is a difficult environment in which to months. Basically the question is, how
put on a contrarian trade because there is long will it take people to forget?’
so much risk aversion right now’, says
I The analysis
This FT article focuses on an interesting story that had been developing in the European
bond markets over the previous few weeks. When the euro was introduced in the late
1990s the yields on government bonds right across the whole eurozone saw a very rapid
convergence. In simple terms this means that they all fell to the level of the lowest yield
that existed at this time. As a result, the yields on offer from the traditionally much more
risky countries like Spain and Greece became virtually the same as those on offer from
much safer countries like Germany and France. The view was that, if the bonds were now
issued in the same currency, they should enjoy the same level of risk and therefore have
identical yields. The yield differential between Italian and German government bonds
which had been as high as 600 basis points fell back to just a few basis points.
You should remember that we use the term ‘basis points’ to show the credit spread that exists
between bond issues. Every percentage point of yield in a bond equates to 100 basis points so
that a yield of 6 per cent is 100 basis points more than a yield of 5 per cent.
However, in the wake of the worldwide credit crisis investors became more reluctant to
take on any unnecessary risk. So, they now placed a premium on buying German govern-
ment bonds rather than the more risky options available in the Greek and Spanish
markets.
As the FT article reported:
[T]he risk premium of 10-year Italian government bonds has risen 12 basis points to
43bp over comparable German bunds since the beginning of the year, while that of
10-year Greek government bonds rose 14 bp to 44.5 bp over Bunds.
The article suggests that the search for better credit risk only partly explains this develop-
ment. The additional factor is the search for greater liquidity attached to certain eurozone
government bond markets. One attraction of the German Bund market is that it has a
highly liquid futures contract attached to the market. This gave bond traders the ability to
utilise these instruments to manage their trading strategies.
The FT article quotes Erik Wilders, head of the Dutch State Treasury Agency: ‘Germany
is the biggest and most liquid market, and that is what investors want right now’.
81
These movements in the European bond market were matched in the credit swaps
market (CDS). The figure quoted in the FT article show that the five-year CDS Greek sov-
ereign debt had risen 28.8 per cent to 56.6 basis points in the past month. The result is
that it now cost investors €56 700 each year to protect €10 m worth of debt against a
default over a 5-year period.
I Key terms
Eurozone This simply refers to all the countries that use the euro as their common currency.
Bond yields When an individual or a company borrows money there is a cost that they have
to pay in order to obtain the funds. If it is a short-term loan (up to one year) this is normally
referred to as an ‘interest rate’. So, we might take out a one-month bank loan with an annual
interest rate of say 8.5 per cent. This is the interest rate, or the cost of obtaining the funds. If a
company needs to borrow funds for a longer time period, this will normally be through the
issue of a bond market security which is usually repaid at a fixed rate of annual interest (this is
called the ‘coupon’) until it is finally repaid on the date that it redeems or matures. The yield
on the bond issue is the cost to the issuer or the return to investor who buys the bond.
Convergence This refers to the process that took place in the late 1990s whereby all the
prospective Eurozone countries saw their government bond yields fall to the level of the lowest
yield that existed at this time. This meant that the yields on offer from the traditionally much
more risky countries like Spain and Greece were virtually the same as those on offer from the
much safer countries like Germany and France. The view was that if the bonds were now issued
in the same currency they should enjoy the same level of risk and therefore identical yields.
Global credit crisis This refers to the crisis that affected financial markets in the summer of
2007. This was caused by the subprime crisis that started in the US. As a result banks became
very reluctant to lend to each other and the interbank markets saw their liquidity dry up.
Government debt These are simply bonds issued by governments to fund the difference
between their spending and revenue.
Spreads This is a measure of the relative cost of issuing more risky bonds. It is best seen with
an example.
Let us assume that the German government has close to zero risk of default. As a result
a 10-year German bund might have a yield of 3.5 per cent. In contrast, a 10-year issue
from the Greek government which has more risk of default might have a yield of 4.5
per cent. This gives us a credit yield spread of 4.5 per cent minus 3.5 per cent ⫽ 100
basis points difference. The spread is determined by a combination of the bond’s
credit rating, liquidity and the market’s perception of its risk relative to the other bond.
AAA rated Most new bond issuers are assigned credit ratings by the various companies that
are involved in this activity. They include Standard and Poor’s and Moody’s. The highest credit
rating allocated by Moody’s is a triple A. For example, this is awarded to the German govern-
ment’s bond issues.
82
Short summary of Moody’s credit ratings
AAA ⫽ Capacity to pay interest and principal extremely strong.

AA ⫽ Differs only in a small degree.
A ⫽ More susceptible to adverse changes in circumstances.
BBB ⫽ Adequate capacity. 4
BB, B ⫽ Speculative.
DEBT FINANCE
C ⫽ No interest being paid.
D ⫽ In default.
Risk premium This is simply the extra financial reward that will be required to convince an
investor to hold an asset that has a risk of returning a capital sum that is less than the original
amount paid for it. For example, you will only buy shares in a company if there is a good
prospect of achieving a financial return well in excess of the interest rate that is available for a
‘risk-free’ bank account.
Bunds Bunds are simply German government bonds. These are used to fund the difference
between Federal government spending and revenue. As normal the benchmark, long-term
government bond is the 10-year maturity.
Sovereign entities This simply refers to a country or a supranational body like the World Bank
or the European Bank for Reconstruction and Development that are both regular issuers of
bonds.
Liquidity premium This term refers to how easily an asset can be converted into cash.
Therefore, notes and coins are the most liquid financial asset. In general, the more liquid an
asset, the lower is its return. Investors will pay a higher price in order to secure a liquid financial
asset. This is what is known as the liquidity premium.
Futures market (liquid futures market) In the financial markets a well-established futures
market will allow traders to deal in a financial market asset at a set price on a specified future
date. For example, a trader could arrange to buy £10 m of a government bond issue from
another bank at a set price on a specific date in the future. The attraction of this deal is that
both parties know now what the price is going to be. There is no uncertainty as this transaction
will not be affected by any subsequent rise or fall in bond prices. A liquid futures market is
simply one where there is a high degree of trading activity which will allow investors to trade
easily.
Credit risk premium This is the higher return that a bond investor will require to compensate
for the possible financial loss due to the bond issuer being unable to make timely payments of
interest or the principal.
Credit default swaps (CDS) This is a financial market instrument that is designed to offer a
bond investor complete protection against the risk of default. Essentially, the seller of the swap
takes over the risk of default on the bond issuer for a one-off payment. In the event of any
default the seller of the swap will be fully liable to pay the par value of the bond and any due
interest payments to the credit swap buyer.
83
Risk aversion Most rational people will always prefer to buy investments that carry the lowest
possible risk. So, if faced with the choice of a perfectly safe government bond (AAA–rated) or a
bond issue from another country with a poor credit history, the rational person will always select
the low-risk option.

1. In the context of the European government bond market explain what is meant by the
term ‘convergence’.
2. According to the FT article what factors have resulted in the recent divergence in gov-
ernment bond yields across the Eurozone?
3. What is meant by the following terms?
I liquidity premium
I credit risk premium.
4. How do bond holders use credit default swaps to minimise the risk on their bond
investments?
You will need the Companies and Markets section of the Financial Times.
Go to the Market Data section. Now go to the Benchmark Government Bond section.
Highlight all the 10-year government bonds from the countries that make up the
Eurozone. Start with the German 10-year bund yield. Now calculate the spread between
this benchmark bond and all the other eurozone government bonds.
Write a short commentary on the current level of convergence between the government
bond yields in the Eurozone.
I Research
Times. You should especially look at Chapter 11 to get more information about the bond
markets.
The topic of Eurobonds is on p. 784.
Edition. There is a short introduction to Eurobonds on p. 297.
Financial Times. The definition of a Eurobond issue is on p. 239.
Hall. You should look at Chapter 3, pp. 64–7 for a brief introduction to bond pricing.
Pilbeam, K. (2006) International Finance, 3rd edn, Basingstoke: Palgrave Macmillan. There is a
useful chapter on Eurobonds starting on p. 304.
84
Macmillan. You should look at Chapter 6.
FT Prentice Hall. You should look at Chapter 5 (pp. 127–8).
Go to www.pearsoned.co.uk/boakes to access Kevin’s blog for additional analysis 4

DEBT FINANCE
85
Topic 5
Capital structure
In corporate finance the term ‘capital structure’ refers to the long-term finance that a
business needs to have in order to fund new investment projects and to maintain its
growth and success. This includes debt issues, ordinary shares, preference shares and
retained earnings. It is regarded as a key topic in corporate finance as companies must
decide in particular on the appropriate balance between equity and debt finance. Before
we examine that debate we must answer three key questions:
1. How much capital does a company need? A company needs enough capital to pay
for its fixed assets (any asset designed to be used for the long term, including build-
ings or new office equipment) and to ensure that there is enough working capital
(the part of capital used to allow the business to trade from day to day, including
stock or cash). The correct level of long-term financing will allow the company to
trade, produce the goods and offer the services that it is involved in.
2. What happens when the company has too much capital? Some companies can
get themselves in a position where they have more long-term finance than they actu-
ally need. This is easily solved. The company should first repay any loans that it does
not require. This can be followed by the payment of special dividends to the share-
holders or a programme of share buybacks.
3. What happens when a company has too little capital? This can be a serious
problem and it is much harder for a company to solve. At a minimum it might
prevent it from taking advantage of some excellent investment opportunities. Even
more seriously it might threaten the whole future of the company if the lack of
capital begins to concern their customers, suppliers or financial backers. In this situ-
ation they need to undertake a series of new capital issues with some urgency. The
problem is that the investors in either new debt or equity issues might be reluctant
to invest more money in a business that is seen to be in financial difficulties. The
message is that a well-run business must anticipate its capital needs well in advance.
This is rather like a successful soccer team where a good manager always adds a new
quality player before he is actually needed. In the same way a well-run business will
be looking to raise extra finance well before it becomes an urgent requirement.
In corporate finance it is essential to understand the important role that a company’s

capital structure plays in all its business activities. When a company looks to raise new
finance, the choice is between equity finance and debt finance. You can read much
more about both types of finance in Topics 4 and 6. At this stage it is important to
understand what is meant by the terms ‘gearing’ or ‘leverage’. If a company has any
level of debt in their capital structure we say in the UK that they are using gearing. In
Capital structure
the US we would say that they are employing financial leverage. In either case the use of
these terms suggests that the company is employing a financial strategy that will amplify
the returns to its shareholders. The use of debt finance can lead to higher rewards for
the owners of a business, but this is normally at the cost of greater risk.
This means that the best choice for companies will depend on their relative risk and cost
profiles. These are set out in the box below. This shows that for companies the issue of
debt capital is considered to be more risky because they must make financial
commitments to the investors in these securities. If they do not meet their obligations to
pay interest or the principal, they risk being forced into liquidation. In contrast, they
make no such promises to the investors in equity finance. These know that they will be
well rewarded in good years, but they must accept any losses in income or capital in the
bad years.
Point of view of the issuing company

Debt capital High risk but lower cost
Equity capital Low risk but higher cost
Before we get into the articles chosen for this section of the book, we should focus on
one more issue: the costs of financial distress and insolvency for companies. One
consequence of a company issuing ever-increasing amounts of cheaper debt capital is
that the resulting increase in gearing (the ratio of debt to equity capital) will reduce the
company’s chances of being able to meet the demands of its bond investors. Failure to
make the required payments of interest or principal is likely to result in the company
being forced into a period of financial distress that will ultimately lead to its becoming
insolvent. There are significant direct administrative costs associated with this whole
process. In addition the risks of corporate failure will lead to a number of indirect costs.
These will include:
1. Their customers may become less ready to deal with them. This arises from the risk
that the company’s insolvency could result in a financial loss for a customer still
awaiting the delivery of some service or product. For example, a number of airline
passengers were left stranded when XL Airways collapsed in September 2008.
2. Their suppliers may also stop trading with a company in financial distress and at risk
of insolvency. This is again because they will fear that they may not get paid for any
goods or services supplied to an ailing business.
3. Their employees may start to leave. It is likely that the most marketable employees in
a company facing financial difficulties will start to search for a safer career opportunity.
4. They may be forced to undertake speedy asset sales at a cut-down price. As the
company is trying to raise funds, it might have to resort to selling its most liquid
assets at a lower price.
It is clear that the direct and indirect costs of financial distress and insolvency are
significant, with the result that companies may look to be far less reliant on debt capital
88
Capital structure
than pure financial logic might dictate. The managers of a company might well end up
with a less than optimal capital structure, but this must be balanced against the reduced
risk of insolvency. There is a lot to be said for a good night’s sleep! It is well worth the
slightly higher costs of funding a business.
In the first article chosen for this section of the book we focus on how different types of
capital are treated when a company gets into financial difficulties. In the second article
5
we focus on the problems of business risk that face a particular UK retail company.
CAPITAL STRUCTURE
Article 16
MyTravel shareholders offered 4 per cent in £800 m debt-to-equity restructuring
Article 17
Blacks Leisure falls into the red
Article 18
UK investors dig in over pre-emption rights

I secured and unsecured bonds;
I convertible bonds;
I preference shares;
I business risk;
I gearing;
I rights issues;
I options for shareholders;
I calculating the ex-rights price;
I companies’ cost of capital;
I role of the Monopolies and Mergers Commission.
89
MyTravel on the brink

In corporate finance it is essential to understand the important role that a company’s
capital structure plays in all its business activities. When a company looks to raise new
finance, the choice is between the extremes of equity finance and debt finance. From the
point of view of the company the issue of more share finance is much less risky as the
company makes no financial commitments to the shareholders. In contrast, the issue of
new bond finance means that the company is now obliged to pay interest each year and
it also has to repay the loan at a fixed date in the future. Financial risk is the name given
to the type of risk associated with this commitment to the debt holder.
In recent years we have seen the development of a number of new financing products
which are debt–equity hybrids. This means that they are somewhere between the two
extremes of equity and debt finance. This includes the use of convertible bonds. In this
article we will see how the various providers of capital are treated very differently when a
company faces the prospect of severe financial distress.
Article 16 Financial Times, 14 October 2004 FT
MyTravel shareholders offered 4 per cent

in £800 m debt-to-equity restructuring
Matthew Garrahan
MyTravel shareholders have been offered 5 p price, this equates to £650 m

just 4 per cent of the embattled travel additional equity or about 80 per cent of
group under an ambitious proposal that the face value of the debt’, he said.
would see £800 m of the company’s unse- However, the move could come unstuck
cured debt converted into equity. if convertible bondholders object to the
Following sharp declines in MyTravel terms.
shares, the price of the stock had already Bank creditors will, in effect, receive
factored in dilution so yesterday’s the face value of their loans in new
announcement will not come as a great MyTravel shares. But convertible bond-
surprise to investors. holders will only receive shares equivalent
Under the board’s proposal, creditors to 30 p for every 100 p invested.
have been offered 88 per cent of the Analysts said it was unlikely the bond-
enlarged share capital, with convertible holders would not accept the proposal.
bondholders in line for 8 per cent should One said: ‘If they say no, they could
they wish to accept it. derail the deal and the business may go
The rest of the shares would be into liquidation’.
retained by existing equity investors. MyTravel has proposed a timetable for
James Ainley, leisure analyst with the restructuring that would see it com-
Dresdner Kleinwort Wasserstein, said the pleted by the end of 2004.
restructuring would imply the issue of On completion, the company’s debt will
about 13 bn new shares. ‘At the current
90
Article 16 MyTravel shareholders offered 4 per cent in £800 m debt-to-equity restructuring
be approximately £140 m of aircraft Non-voting preference shares will be

finance leases. awarded to creditors and bondholders
In order to satisfy European Union from outside this area.
rules as to airline ownership, MyTravel Provided the bondholders and creditors
has also proposed issuing ordinary shares accept the proposal, the company will
to creditors and bondholders from coun- have a new, five-year overdraft facility 5
tries in the EU and European economic worth £167 m.
CAPITAL STRUCTURE
area.
I The analysis
The company MyTravel plc has run into serious difficulties. As a result there is now a pro-
posal for a major restructure of the financing of the business. So who are the winners and
who are the losers in this situation?
The debt holders in any failing business are always in the strongest bargaining position.
They are higher up the creditor hierarchy than the preference shareholders or the ordinary
shareholders. As a result, the plans from the company’s board of directors would offer 88
per cent of the new enlarged share capital to the various debt holders. In effect, they will
see 100 per cent of the face value of their debt converted into shares in MyTravel plc. So,
the monetary value of their investment has been protected, although they now have seen
the money that they were owed by MyTravel converted into equity finance.
The middle of the creditor hierarchy is represented by the convertible bond holders
who are being offered a further 8 per cent of the share capital. This means that they would
get back 30 per cent of their existing investment in the form of shares.
At the bottom of the hierarchy are the ordinary shareholders who are being offered just
4 per cent of the expanded share capital. In order to go ahead with this course of action
the company’s board of directors will need a positive vote in favour from the various bond-
holders. One analyst quoted in the Financial Times article speculates that a rejection could
derail the deal and the business may go into liquidation. This would leave the various
parties fighting over any assets that the company still owns.
This article shows perfectly the risks that are faced by ordinary shareholders. If a
company is doing well, they reap the rewards in terms of capital gains through a sharp rise
in the share price plus higher income in the form of rising dividend payments. However,
if the company hits problems, they act as the shock absorber for the other providers of
capital. In other words, in times of trouble they will see a sharp fall in the capital value of
their shares while the bond holders will normally be insulated against the most severe con-
sequences of corporate failure. As a counter to this lower risk the bond holders accept
much lower potential returns.
In summary, this article shows the stark choice that investors face. If they purchase good-
quality corporate bonds, they are normally getting a low-risk but also a low-return investment.
In contrast, if they buy shares from the same company, they are getting a high-risk asset which
carries with it the potential for very substantial returns. This investment decision is often driven
by the attitude of the individual investor to risk and return. The final choice is yours!
91
Article 16 MyTravel shareholders offered 4% in £800 m debt-to-equity restructuring
I Key terms
Capital structure This refers to the long-term finance that a business needs in order to trade.
This is made up of debt and equity finance. The debt finance will normally be in the form of a
bond that carries fixed-interest payments and a set date when it will be redeemed. In contrast,
there are no guarantees of any financial returns to the providers of equity (the shareholders). If
a company does well and is highly profitable, it is likely that there will be significant dividends
paid to the shareholders. However, if the company runs into financial difficulties, the dividends
will be cut back and they might disappear altogether. It should be clear that in terms of capital
structure the shareholders take a greater risk than the debt holders. As a result, it is reasonable
for the shareholders to expect a higher level of financial returns to compensate for this higher
risk.
See Articles 2 and 3 to find these issues discussed in more detail. It shows how activist share-
holders are increasingly seeking management changes in companies that do not perform in line
with their expectations.
Convertible bonds On the face of it, these are just like conventional bonds as they are interest
bearing and have set redemption dates. However, they give the holder the right to convert their
bonds into the shares of the issuing company.
Hint: For a more detailed discussion of convertible bonds you should look at Article 13 which
examines the Japanese convertible bond market. There is a more detailed definition of convert-
ible bonds in the ‘Key terms’ section.
Secured and unsecured debt Companies will normally have a range of different types of debt
capital. The lowest-risk form of debt capital will be secured debt. This means that the debt is
secured on various assets owned by the business including property or plant and machinery. If
the business goes into liquidation, the secured bond holders will have a claim on these assets
so that their investment will be protected. In contrast, the unsecured debt holders do not enjoy
this form of protection. They accept a higher degree of risk which must be compensated for by
a higher level of return.
Non-voting preference shares In many ways preference shares can be seen to be very similar
to bond finance. They normally pay dividends at a set percentage very much like the coupon
on a bond issue, and in addition they will normally have a set redemption date. However, unlike
bonds, the dividends on a preference share are paid at the discretion of the board of directors
of a company. Most preference shares are non-voting, which means that the holders will not
have the right to vote on corporate policy at the annual general meeting.

1. With reference to this article comment on the relative risk and reward profile of ordinary
shareholders, preference shareholders, convertible bond holders and secured bond holders.
2. Explain why the ordinary shareholders receive only 4 per cent of the new expanded
share capital.
3. It is often said that shareholders act as ‘shock absorbers’ for the company. In the
context of this article explain what this means.
92
Article 16 MyTravel shareholders offered 4 per cent in £800 m debt-to-equity restructuring
4. What is meant by the term ‘convertible bonds’? What are the advantages for investors
who buy convertible bonds rather than ordinary bonds?
5. What is meant by the term non-voting ‘preference shares’?
6. Why are preference shares referred to as hybrid securities?
7. What are the likely outcomes if the bondholders reject the restructuring proposal? 5
CAPITAL STRUCTURE
Share Price Service. This is normally the two pages inside the back page of the Companies
and Markets section.
In 2007 Thomas Cook merged with MyTravel plc.
1. What is the current share price for Thomas Cook plc?
2. What is the high and low for this share price in the last 12 months?
3. What is the current P/E ratio for Thomas Cook?
4. How does this P/E ratio compare to other transport companies?
I Research
Look at pp. 252–7 for a very clear introduction to different types of bond issues.
should look especially at Chapter 11, pp. 441–3 to get more information about convertible
bonds. It sets out very clearly the advantages of convertible to both the issuers (companies) and
the investors.
Berk, J. and DeMarzo, P. (2009) Corporate Finance, Harlow,UK: FT Prentice Hall Financial Times.
The topic of preferred stock is explained on p. 755.
Gitman, L. (2009) Principles of Managerial Finance, Harlow, UK: Pearson International Edition.
There is a clear discussion of the differences between equity and debt capital starting on p. 330.
McLaney, E. (2009) Business Finance Theory and Practice, Harlow, UK: FT Prentice Hall Financial
Times. There is a brief introduction to preference shares on pp. 13–14.
Hall. You should look at Chapter 16.
FT Prentice Hall. You should look at Chapters 4 and 5.
93
Blacks Leisure hit by global warming

Business risk is an important concept in corporate finance. This is the general risk that
applies to all companies that operate in any business environment. For example, a
company might see a sharp drop in sales because a rival business brings out a better
product, or another company might be hit by a change in tax laws that has a negative
impact on the profitability of a business. No matter what a company does, it is impossible
to remove all business risk. It is a fact of life for companies. Instead, they must do their best
to protect themselves against the most severe damage that might be caused to their
businesses.
In this example we focus on Blacks Leisure, which has seen a sharp downturn in its
financial performance as a result of a change in weather patterns. The company blames
this business risk on the impact of global warming.
Blacks Leisure falls into the red

Tom Braithwaite and Maggie Urry
Background However, Blacks went into the red fol-

Retailers are fond of blaming the weather lowing an exceptional charge of £13.9 m,
when things go wrong. Blacks has gone a the cost of closing about 45 loss-making
step further by blaming climate change. stores, which mainly trade under its worst
‘Blacks and Millets have historically performing Millets fascia.
benefited from the traditional British Investors in Sports Direct, the sports-
climate of somewhat wet summers and wear group that floated in February, are
cold winters’, it said yesterday as it exposed to the fortunes of Blacks via a
reported a loss for the year that was ‘the 29.4 per cent stake. Mike Ashley, the con-
warmest and driest on record’. troversial founder and majority
Moreover, the new year had seen shareholder of Sports Direct, bought the
unseasonably warm spring weather’. stake in his own name last year but rolled
it into the company upon flotation.
Both companies have suffered a signifi-
Blacks Leisure has slashed its dividend cant sell off this year: shares in Blacks are
as it tries to stabilise the troubled down 37 per cent, while those in Sports
business, heaping more misery on both Direct have fallen 25 per cent since it
its shareholders and those of Sports joined the market in February.
Direct. Shares in Blacks fell 2 p to 259 p yes-
Results for the year to March 3 showed terday, while those in Sports Direct closed
the outdoor wear group just managed down 31⁄4 p at 226 p.
to break even, with underlying profit of Russell Hardy, chief executive of
£100 000 on sales little changed at Blacks, said there had been ‘some
£298 m, in line with expectations after its pleasing signs of good growth from the
most recent profit warning. camping business’ but that the company
94
Article 17 Blacks Leisure falls into the red
had endured a ‘tough April’. In the first Blacks is cutting its final dividend by
eight weeks of the new financial year, to 6 p to 2 p, leaving the total for the year at
April 28, sales were up 2.7 per cent and 5.3 p, down from 11.3 p last time.
like-for-like sales had increased 0.8 per The board said it regarded ‘the reduc-
cent. tion in the final dividend as a proper
Blacks has traditionally performed well measure reflective of the poor trading per- 5
in wet summers and cold winters and formance’.
CAPITAL STRUCTURE
claims that ‘global warming’ has brought During the year, like-for-like sales fell
about much of its weaker performance. 2.7 per cent and high operational gearing
‘In terms of weather proofing the busi- meant margins fell sharply.
ness, we’ve done a lot of work for this After taking the £13.9 m charge, Blacks
season but my sense is it’s going to take reported a pre-tax loss of £13.8 m (£21.4 m
another couple of seasons to put the busi- profit). Losses per share were 29.7 p
ness in a position where it can cope with (earnings of 34.6 p).
consistently drier weather’, said Mr
Hardy.
I The analysis
Anyone who has been on an outdoor activity holiday will know the name Blacks. For many
it is the shop of choice for walking and climbing gear. The last time I was in a Blacks store
getting some new trekking boots I remember being most impressed by its indoor walking
ramp which is used to try them out. It is probably a slight simplification but, as a business,
Blacks Leisure can be split into two main parts. The core activity is the outdoor leisure retail
product market including clothing and boots. Perhaps less widely known, it also sells
boardwear gear as it is the UK’s distributor and retailer of O’Neill products.
This Financial Times article focuses on its latest very poor set of financial results which
were for the year to 3 March 2007. In this period the company broke even on sales of
£298 m. This was very much in line with the market’s expectations following a very recent
profit warning. However, an exceptional charge of some £13.9 m took the company into
the red. This charge resulted from the closure of a significant number of loss-making
Millets stores. Shareholders in the group have suffered a sharp fall of 37 per cent in the
Blacks share price in the last year.
The chief executive, Russell Hardy, saw some encouraging signs despite these bad
figures. He claimed that the company had suffered in the face of the impact of climate
change. A company like Blacks performs best with wet summers and cold winters, so the
onset of drier summers and milder winters hits sales badly. The company was attempting
to insulate itself from the impact of global warming. This is most easily achieved through
product diversification.
This is a classic example of a business risk damaging a company’s performance. As
usual, it is the shareholders who take the biggest hit. In this case they have seen the final
dividend slashed by 6 p to 2 p. So, the total dividend for the year fell from 11.3 p to just
5.3 p. This dividend reduction combined with the sharp fall in the share price means that
business risk has resulted in a disastrous year for Blacks’ shareholders. As the advertisers of
95
certain financial products are forced to say ‘always remember the price of shares can go
down as well as up’. What they do not say is that the cause is normally business risk.
I Key terms
Business risk This refers to the general risk that can impact on a company’s cash flow or prof-
itability. It could be caused by general economic conditions (consumer spending, level of
interest rates, etc.) as well as more specific company factors (changes in key staff, strike action
by employees, etc.).
Hint: If you look at Topic 11 you will see more discussion of the risks facing companies. Article
31 shows how companies can manage some forms of currency risk.
Break-even A company achieves break-even when its sales revenue equals total costs. These
costs will include some fixed costs as well as the variable costs that will be dependent on the
level of sales.
Gearing This refers to the proportion of debt in the company’s capital structure. A company is
termed ‘highly geared’ if it has a large amount of debt finance compared to a small amount of
equity finance. In contrast, a low-geared company will be largely financed by equity finance.

1. What is meant by the term ‘business risk’? Select any five FTSE 100 companies and
identify an example of business risk that might impact on them in the next year.
2. Explain what is causing the business risk associated with Blacks Leisure.
3. What steps could Blacks Leisure take to try to minimise this type of business risk?
4. Just about a year ago you advised a friend (perhaps, now a former friend!) to purchase
1000 shares in Blacks Leisure. Write a short report (300 words max) explaining the
negative performance of these shares in the past year. Give a view on their likely per-
formance in the year ahead.
Hint: Get hold of the company’s latest report and accounts and visit its website.
I Investigate FT Data
You will need the Companies and Markets section of the Financial Times. Read through the
first few pages of this section in today’s edition of the Financial Times.
Attempt this short activity:
1. Identify any two examples of a company’s share price being impacted by a form of
business risk.
Hint: If you cannot see an example in the various company reports look instead at the
Markets Report at the back of the Companies and Markets section. This shows the main
share prices movements in London and gives a reason for the change in most cases.
96
Research
Look at pp. 396–8 to see business risk defined.
Times. You should especially look at Chapter 21, p. 803 to get more information about business
risk.
5
CAPITAL STRUCTURE
The link between leverage and risk is on p. 492.
Edition. There is a look at the popular sources of risk affecting financial managers on p. 229.
Financial Times. You will find a section on risk and business finance on p. 5.
Hall. You should look at Chapter 7, pp. 163–4 to see an explanation of the different types of
risk.
FT Prentice Hall. You should look at Chapter 8, p. 224 to see a section on business risk.
97
Looking for the ‘right’ way forward

When I am setting an exam question for my second year Finance students I always look
for a real corporate finance activity that requires them to demonstrate a combination of
good writing and quantitative skills. That is why I always tend to incorporate some aspect
of a real rights issue into a question about capital structure.
People who buy shares in a company get few financial promises or guarantees. This is
in sharp contrast to the bond holders who get a firm commitment from the company to
pay them a certain amount of interest each year (the coupon) as well as the eventual
repayment of the loan (the principal). The shareholders hope the company will perform
well which will result in them receiving substantial dividend payments as well as a rise in
the capital value of their shares. One of the few promises that a company does make to its
shareholders is now coming under threat. This is where a company decides to raise
additional finance through the issue of more share capital. The existing shareholders must
be given the first opportunity to buy any new shares. This is important as it guarantees
that they will be able to maintain their existing percentage of the company’s share capital
if they decide to exercise their right to purchase any extra shares that they are offered.
Article 18 Financial Times, 22 October 2007 FT
UK investors dig in over pre-emption

rights
Kate Burgess
European Union authorities have infuri- towards a deadline of next March for the
ated UK investors by suggesting that first draft of new legislation.
pre-emption rights – the right of first It comes just three years after the UK
refusal to new share issues that most government asked Paul Myners, former
investors regard as sacrosanct – could be chairman of Marks and Spencer, to look at
removed. whether pre-emption rights hampered
‘Investors jealously guard their pre- businesses from ‘raising finance to inno-
emption rights. If there is one way of vate’.
infuriating the City, it is threatening to Mr Myners concluded that the rights
take them away’, says a corporate broker were a ‘cornerstone of company law’ that
at a US investment bank. should not be removed. Pre-emption was
The latest assault on shareholders’ sen- an important safeguard for shareholders
sibilities comes from the European although they needed to be more flexible
Commission’s review of European about waiving their rights on occasion, he
company law that enshrines the principle said.
of pre-emption. He argued that pre-emption instilled
The review is nearing the end of its con- confidence among investors and therefore
sultation stage, with responses due this had a direct impact on lowering compa-
month. The commission is working nies’ cost of capital. In the US, for
98
Article 18 UK investors dig in over pre-emption rights
example, where these rights are less tially higher – as much as 6 per cent – and
entrenched, the risks are higher and the shares fall to discounts after a placing.
costs of raising capital greater. By comparison, rights issues in the UK
Mr Myners’ findings echoed the conclu- attract fees of less than 3 per cent. So far,
sions of the Monopolies and Mergers the voices of those in favour of pre-
Commission investigation, which five emption seem to be drowning out those 5
years earlier concluded that the rights against.
CAPITAL STRUCTURE
were no more expensive than non-pre- The CBI has written to the European
emptive issues. Commission arguing that pre-emption
His conclusions allowed investors to needs to apply across the EU as part of a
breathe a sigh of relief. They could buy uniform set of core principles to develop a
shares safe in the knowledge that their single market.
holdings would not be diluted without The CBI was minded to suggest modifi-
their agreement by companies selling cation at the wider EU level, because it
equity at preferential prices to third could be retained in domestic regulation.
parties. It meant investors could call a But, says Rod Armitage, head of
halt to profligate spending of shareholder company affairs: ‘Pre-emption rights are
funds. And when shareholders said no, a long-established feature of the investor-
companies could not gainsay them by company landscape. None of our members
issuing new shares to more management- lobbied for change and they were not in
friendly groups. favour of them being done away with.’
The present rules in the UK insist if The London Stock Exchange has also
companies wish to issue more than 5 per weighed in, pointing out that safeguards
cent of their existing equity capital in a such as pre-emption rights play a signifi-
year, or 7.5 per cent over three years, they cant part in London’s competitiveness as
must get shareholders’ approval. a financial market.
But now, the European Commission has ‘Pre-emption rights are an important
reopened the debate as part of a wider and highly regarded aspect of investor
exercise to overhaul and simplify protection’, says Adam Kinsley, LSE
company laws that have been around for director of regulation.
more than 20 years. Pre-emption rights, The most heated response has been
which were introduced in the UK in the from UK investors.
1980s, are part of the review. The com- Karina Litvak, head of corporate gover-
mission has suggested that pre-emption nance at F&C Asset Management, says:
rights could be modified or even repealed ‘This is a non-negotiable for most
and the UK government has asked for investors.’
responses. The Association of British Insurers,
The biotech industry has in the past backed by the UK’s biggest shareholder
argued that pre-emption rights were cum- groups, including Morley and Insight, has
bersome, time-consuming and expensive, written to the government and the com-
and companies needing regular cash injec- mission outlining investors’ concerns.
tions quickly say that tapping the same It argues that pre-emption rights are
investor base for the necessary funds can ‘vital in protecting investors’ and have an
add to the costs of capital. EU-wide impact, affecting anyone
These companies have pushed hard for investing across borders in EU
the same kind of freedom US rivals have companies.
to issue shares. But in the US fees on However, the decisive factor will be the
equity fund-raisings are usually substan- position the government takes. And,
99
worryingly for many investors, they have make clear to the government the
detected a persistently lukewarm support strength of feeling on pre-emption rights
from the government for pre-emption so that it will have no doubt over what
rights. position to take in discussions with other
As Peter Montagnon, director of invest- member states.’
ment affairs at the ABI, says: ‘We want to
I The analysis
Not for the first time the European Union authorities are proposing to take some action
that will upset part of the UK population. Normally the targets are the fisherman facing
yet more quotas and the market-stall holders still wanting to sell their fruit and vegetables
in old-fashioned pounds and ounces. In this case the affronted group are the investors in
companies who face the threat of losing their much coveted pre-emption rights. As the
corporate broker is quoted as saying in the FT article:
Investors jealously guard their pre-emption rights. If there is one way of infuriating the
City, it is threatening to take them away.
The latest threat comes from a review of European company law that was getting close to
the end of its consultation period.
This is not the first time that rights issues have been threatened in recent years. The FT
article reports that just three years ago the ex-chairman of Marks and Spencer, Paul
Myners, had been asked to look into the question of whether pre-emption rights had a
detrimental effect on the UK companies’ ability to fund new investments. He concluded
that they were in fact a ‘cornerstone’ of UK company law, which should be safeguarded.
In fact he went as far as to suggest that their existence re-enforced the confidence of share-
holders and this actually reduced the cost of capital for UK companies. So, if you took
rights issues away, the cost of company finance would actually rise. The result of this report
combined with the outcome of a Monopolies and Mergers Commission Report was that
UK investors were able to sleep easy in their beds safe in the knowledge that rights issues
would remain. As a result, there was no danger that companies would be able to dilute
the value of existing shareholdings by issuing additional share capital to new investors.
The article usefully includes the rule that UK companies must get shareholders to for-
mally approve any share issues that involve more than 5 per cent of the existing share
capital in any year, or 7.5 per cent over a three-year period. It also shows that this issue is
still important for a number of bodies that look out for the interests of UK shareholders.
The London Stock Exchange is quoted as saying:
Pre-emption rights are an important and highly regarded aspect of investor protection.
Other support for the status quo comes from the Confederation of British Industry (CBI)
and the Head of Corporate Governance at Foreign and Colonial Asset Management who
100
says this is ‘non-negotiable for most investors’. Against this background this looks like one
battle the European Commission might not win. It looks like rights issues are here to stay
which is good news for me as I start to plan my next exam paper!
I Key terms
5
Pre-emption rights This refers to one of the very longstanding principles of corporate law. It
CAPITAL STRUCTURE
gives all shareholders the first right to buy any additional shares being sold by companies. The
new shares would be offered to existing holders in direct proportion to their existing holdings.
So that if you owned 10 per cent of the existing shares in a company you would be given the
right to buy 10 per cent of the new shares being sold via a rights issue. These additional shares
are normally sold at a significant discount to the existing market share price to ensure a suc-
cessful completion of the transaction.
The shareholders involved have three choices:
1. They can exercise their right, which means that they agree to buy the additional
shares.
2. They can formally renounce the right, which will result in the company selling their
rights on their behalf.
3. Finally, they can do nothing. In this case the company will still normally sell the rights
on behalf of the shareholder anyway.
Corporate brokers These are important financial institutions that will make a market in a
company’s shares. This means that they must be willing to quote both buy and sell prices,
enabling investors to deal in the shares. They could also act as an adviser to a company that
was organising a new share issue.
Investment bank An investment bank acts as an intermediary between the issuers of capital
(governments and companies) and the investors in capital (pension funds and insurance
companies). The staff employed in an investment bank will work either in the investment bank
division (IBD) which deals with the new issues of debt and equity capital or the markets division
which deals with the investors in new bond and equity deals.
Shareholders In most companies the shareholders provide the bulk of the long-term finance.
This makes them the key stakeholders in the business. They are the owners of the business and
the managers must always remember that they are merely acting as agents working on behalf
of the shareholder who are the principals. We normally assume that the primary objective of a
company is to maximise the wealth of its shareholders. In practice, this is simplified to max-
imising the company’s share price. The shareholders range from private investors with small
stakes in the business right up to the large financial institutions that often own a significant per-
centage of the equity of a business.
Companies’ cost of capital This refers to the financial return that is expected by an investor in
a company’s debt or equity issues. It is easy to understand if you think about it from the
investor’s point of view. The cost of capital is seen as the annual percentage return that an
investor would expect if they were buying shares or bonds issued by a company. Let us look at
an example:
101
Say we have a company called RBL plc.

They might have a 50/50 split between the amount of their equity and debt capital.
We would expect the shareholders to demand a higher rate of return on the equity
finance than the bondholders because it is much more risky.
RBL’s cost of equity finance might be 10 per cent. This means that shareholders
would only hold their shares if there was a reasonable expectation that the shares
would give them an annual return of at least 10 per cent.
At the same time the cost of debt capital might be just 6 per cent reflecting the
lower risk faced by the bondholders.
This means that the company’s overall cost of capital is a simple average of the two
which gives us a figure of 8 per cent.
Monopolies and Mergers Commission The Competition Commission actually took the place
of the Monopolies and Mergers Commission in 1999. In simple terms, the MMC had the task
of ensuring that the market in the provision of various goods and services remains competitive.
They were required to undertake investigations and make recommendations in the case of
takeovers to ensure that no single company had a dominant influence over a particular market.
Diluted (shareholdings) This arises when a company issues additional share capital. The result is
that the existing shareholders see a diminished value in terms of their voting power and their value.
Shareholders’ funds Put simply, this is a measure of the total value of the shareholders’ stake
in the company. It is made up of the total share capital plus any reserves.
Gainsay This means to deny or contradict something or somebody. In this context the FT
article suggests that the need to get shareholder approval for a new share issue prevents
companies from acting against the interests of their shareholders by going to ‘more
management-friendly’ investors to fund a new share issue.
Equity fund-raising This simply refers to the company raising additional finance through the
issue of extra share capital.
London Stock Exchange (LSE) This is the main stock exchange in the UK. It enables
companies to raise new equity finance through their initial public offer (IPO) and subsequent
share issues (rights issues). In recent years it has become increasingly international with
companies from all over the world raising finance on the LSE.
Investor protection This refers to the defence of shareholders’ rights including in this case the
first opportunity to buy any new shares issued by the company.

1. What is meant by the term ‘pre-emption rights’?
2. Why are rights issues usually made at a discount to the current market share price?
3. Explain the argument that the existence of pre-emption rights might result in a higher
cost of capital for companies.
102
4. What is the normal level of fees that a company should expect to pay to an investment
bank that organises and underwrites a new rights issue for them?
5. Why might the existence of rights issues actually reduce the cost of capital for UK
companies?
6. The FT article suggests that the ‘biotech industry has in the past argued that pre-
emption rights were cumbersome, time-consuming and expensive, and companies
5
needing regular cash injections quickly say that tapping the same investor base for
CAPITAL STRUCTURE
necessary funds can add to the costs of capital’.
Discuss the arguments in favour of this viewpoint.
Share Price Service. This is normally the two pages inside the back page of the Companies
and Markets section.
Now go to the Telecommunications sector. Look at the current share price data for British
Telecom.
1. If BT were to announce a 1 for 5 rights issue at 20 per cent below the current market
share price, what would the price of each additional share be?
2. If a shareholder had 500 BT shares, how much would they have to pay in total to exer-
cise their rights fully?
3. What would you predict would be the value of the BT shares after the rights issue
process has been completed (ignore all other influences on the share price)?
Research
Look at pp. 212–15 for a very clear introduction to rights issues.
Times. You should especially look at Chapter 10 to get more information about rights issues.
pp. 383–6 are the most important.
Rights issues are explained on pp. 770–1.
Edition. There is a discussion on the process of organising a rights issue on pp. 332–3.
Financial Times. There is a section on rights issues on p. 229.
Hall. You should look at Chapter 16, pp. 427–32.
FT Prentice Hall. You should look at Chapter 4, pp. 1031–1110.
103
Topic 6
Equity finance
In corporate finance equity finance is represented by the ordinary shares that a company
issues. These are generally the main providers of long-term finance with the holders
receiving high returns in good times but suffering large losses when a company’s
prospects take a dive. The ordinary shareholders are the owners of the company and as
such have a number of important rights.
1. The rights of shareholders:
I They get to vote at a company’s annual general meeting (AGM). This will include
issues such as the make-up of the board of directors.
I They will be asked to approve any strategic corporate moves being considered by
the company. These will include proposals for mergers and takeovers.
I They are entitled to receive their share of any dividends paid by the company. It
should be noted, however, that no company is obliged to distribute any annual
dividends. The level of these payments will reflect the trading performance of the
company and the investment opportunities that are open to it.
I They will get the first option to buy any new shares issued by the company.
I Finally, they can expect to be kept informed of the performance of the company.
At a minimum this will mean that the company sends them an annual report and
set of accounts.
2. Equities are risk capital. When you read the Companies and Markets section of the
Financial Times you will quickly understand that ordinary shares are a perfect example
of what is meant by the term ‘risk capital’. So that when the company is doing well
the shareholders will see their wealth grow rapidly through dividend payouts and
share price appreciation. However, the other side of the coin means that when a
company starts to run into difficulties, it is the holders of equity finance who have
most to fear. In the first instance, any dividend payments will be reduced or maybe
cut out altogether. The ultimate risk is, if the company goes into liquidation, the
shareholders are last in the queue to receive their money back. Indeed, in most cases
they get nothing. The message is that, if the shareholder is wise or lucky, or both,
then buying equity finance can open up the possibility of an individual becoming
very rich as the company prospers. At the same time, if they buy into a business on
the slide they can soon see their wealth go up in flames. Always remember that
equity finance is high-risk and high-return finance. For investors the warning is clear.
If they do not like risk they should invest their money elsewhere.
Equity finance
3. Authorised shares. When a company is first established, the total number of shares
that it can issue will be set. This is known as the ‘level of authorised shares’. In prac-
tice, they will not issue anything like this amount initially. The rest of the shares are
known as the authorised shares that are as yet unissued. These shares can be issued
by the company’s board of directors at any stage in the future through what is
known as a ‘rights issue’ or a ‘placing’.
At the outset new shares are assigned a par or nominal value; however, in contrast to
bonds this is of little practical significance. In the case of bonds the par value is what
is received by the holder on maturity. This is not the case for shares. The company’s
market share price is of far greater importance. So, if you look at a company’s set of
accounts it will show the issued share capital at this very low par value. To get an
accurate gauge of the value of these shares you must add in the share premium
account, which is a measure of the difference between the price the company sold
its shares for and their much lower par value.
4. Limited liability. If the shareholders are the providers of risk capital, they do at least
know that their maximum financial loss is represented by the amount that they
invested in the shares. This is because they have what is known as ‘limited liability’.
As a result, anyone who is owed money by a company that goes into liquidation
cannot turn to the ordinary shareholders for redress. If you invest £10 000 in the
shares of a business that goes bankrupt, your maximum loss will be the amount that
you invested in the shares. This may be of some comfort.
5. Preference shares. Before we start to analyse the articles in this section we should
finally discuss preference shares. From their name you might think that they are just
another form of equity capital, but this would be wrong. Although they are part of
shareholders’ funds, they should not be regarded as being equity finance. One
important difference between preference shares and ordinary shares is that the
former normally carry no voting rights.
Preference shares get their name from their two key characteristics:
1. They have their dividends paid before any payments to ordinary shareholders.
2. If the company is wound up, they will come before ordinary shareholders in terms of
any capital repayment.
There are four main types of preference shares:

1. Redeemable. Most preference shares have a fixed date when the company will
repay the initial capital invested in them.
2. Cumulative. This means that any preference share dividends not paid in one year
will accumulate to be paid in the next year. So, if the normal 10p dividend was due
in year 1 but could not be paid, this would result in 10p extra being paid in year 2.
The company would not be allowed to pay any ordinary dividend until these arrears
are paid in full.
3. Participating. Here the holder receives a preference dividend plus a percentage of
106
Equity finance
the ordinary dividend. This gives the holder of these preference shares a potential
significant upside if the company prospers.
4. Convertible. The holder of a convertible preference share has the option to trade their
preference share for an ordinary share on a specific date and for a fixed price. For
example, they might be able to trade three preference shares for one ordinary share.
6
If you want to see what shares a company has issued in practice you should consult the
EQUITY FINANCE
London Share Service (this normally covers a couple of pages inside the back page of
the Companies and Markets section of the Financial Times). A good sector to look at is
the Banks.
For example, on the day I wrote this Lloyds Banking Group had the following:
Ordinary shares priced at 65 p.

8.0884% Preference shares priced at £545
6.475% Preference shares priced at 59
9 ¼% Preference shares priced at 78.50
9 ¾% Preference shares priced at 90
In our analysis of equities the following four articles are discussed in this section:
Article 19
IPO values Hargreaves at £750 m
Article 20
Hargreaves Lansdown soars on debut
Article 21
Valuing Sainsbury’s
Article 22
Woolies investor opposes sale

I the definition of listing;
I initial public offer;
I the use of unit trusts;
I some key financial ratios;
I private equity bidders;
I share valuation techniques;
I property assets;
107
Equity finance
I sale and leaseback;

I emerging markets;
I impact of economic slowdown on retail sector;
I business and financial risk;
I leases.
108
Hargreaves’ founders float all the way to

the bank
These two articles show the rewards on offer to individuals who are willing to take the risks
6
involved in creating a new business. Back in 1981 Peter Hargreaves and Stephen
EQUITY FINANCE
Lansdown combined to establish a company that sold financial investment products to
private clients. Over the years they have built up a discounted broker business that has
challenged the more established financial institutions and allowed their clients to buy
investment products free from the normally exorbitant initial fees. This new share issue
enables the founders to release part of their equity stake in the company, however, even
now they remain significant shareholders as well as key executives.
IPO values Hargreaves at £750 m

Sarah Spikes and Lina Saigol
Hargreaves Lansdown, the Bristol-based company chairman, in 1981. Both are

private-client stockbroker and financial chartered accountants.
adviser, will list 25 per cent of its shares on Jonathan Bloomer, the former chief
Tuesday in an offering that will value the executive of insurer Prudential, is among
company at about £750 m, making it the the company’s non-executive directors,
biggest UK financial services initial public along with Mike Evans, formerly chief
offering since Standard Life last year. operating officer for Skandia UK, a unit of
Peter Hargreaves, chief executive, said the Swedish insurer taken over by Old
he expected the shares to be priced near Mutual last year.
the upper end of the 140 p to 160 p indica- If the shares list at the top of the range at
tive range that the company gave earlier 160 p a share, the market value would be
this month. £759 m, giving the group a price to earnings
He said the offering was heavily sub- ratio of 15 times. This is above the level at
scribed. ‘It was well received by most which many UK-listed institutional stock-
private and institutional investors on our brokers trade but still below the ratings of
roadshow.’ some private-client stockbrokers.
Private-client customers of Hargreaves Mr Hargreaves and Mr Lansdown
Lansdown are taking a third of the together own about 80 per cent of the
offering while institutional investors are company and plan to remain significant
buying the other two-thirds. Nearly all of shareholders.
the institutional investors buying shares Their holdings after the listing will be
are UK-based, as the company marketed worth about £600 m.
the offering almost exclusively in the UK. In the six months ended December 31,
The group is raising no new money. revenue grew 35 per cent to £43.3 m.
Mr Hargreaves founded Hargreaves Since 1997, revenue has increased by at
Lansdown with Stephen Lansdown, the least a fifth each year.
109
Article 20 Hargreaves Lansdown soars on debut
Hargreaves Lansdown soars on debut

Sarah Spikes
Shares in stockbroker Hargreaves because it was serving a market that is

Lansdown soared by more than 30 per not well targeted by other companies:
cent on their London Stock Exchange investors with between £50 000 and
debut, as investors piled in hoping to £200 000 of assets to invest. Private client
profit from increasing savings rates in the stockbrokers tend to target wealthier
UK. clients.
Shares opened at 160p and rose to ‘There are 6.9 m mass-affluents (in the
close at 2091⁄2 p, adding £232.4 m in value UK), many fed up with years of poor
to the 26-year-old Bristol-based financial service from life (insurance) companies’,
adviser and stockbroker which finished analysts at company broker Citigroup said
the day with a market capitalisation of in a note.
£991.4 m. They added that Hargreaves Lansdown
Founders Peter Hargreaves and has the only quoted platform in the UK
Stephen Lansdown gained an extra that markets directly to investors. It has
£139 m more than anticipated, as the 60 350 000 clients. The main products that
per cent holding they retained increased Hargreaves Lansdown sells to its clients
in value from £455.4 m to £594.8 m. are unit trusts.
The price–earnings ratio implied by Clients often pay 5 per cent of the
160 p was about 14 times 2009 earnings, investment upfront when they invest in
roughly in the middle of the range unit trusts through brokers. But about
between the highest and lowest rated UK ten years ago Hargreaves Lansdown inno-
stockbrokers and asset managers. But at vated and started to offer unit trusts with
the end of trading, the company was large discounts to this 5 per cent rate and
trading at more than 19 times estimated now charges no upfront fees on unit
2009 earnings. trusts.
Investors said that Hargreaves
Lansdown merited a premium rating
I The analysis
Peter Hargreaves and Stephen Lansdown founded their business ‘Hargreaves Lansdown’ in
the early 1980s. They established a discount broker to serve private investors looking to
invest their spare cash. Their unique selling point was that they did not target the super
rich who were traditionally served by the private banks, but instead reached out to the
growing middle classes who had an increasing amount of disposable income and a desire
to invest in financial markets.
Unit trusts are one of the main financial products that they offer to their investors. The
big attraction of using a broker to purchase these funds is that they offer significant dis-
counts on the initial charges. If you go direct to a unit trust provider they will take an
upfront charge which can often amount to 5 per cent of the total investment. This acts as
110
a powerful disincentive to private investors. A few years back Hargreaves Lansdown

opened up this market by initially offering big discounts on these charges and then vir-
tually eliminating them altogether.
The first of the articles previews the initial public offer (IPO) for Hargreaves Lansdown.
The shares were expected to be offered at a price somewhere in a range of 140–160 p.
The final price would be determined by market conditions on the actual day of the sale. 6
In advance the issue was being heavily marketed in the UK to both private and institutional
EQUITY FINANCE
investors. The Chief Executive, Peter Hargreaves, was reported as saying ‘It was well
received by most private and institutional investors on our roadshow’. The company had
one massive advantage as it came with an already established list of potential investors
from their existing clients who by definition were likely to be interested in a new share
issue.
The second article reports on the outcome of the IPO with the shares selling at the top
end of the range at 160 p. A positive trading environment saw them rise further to close
at 209.5 p by the close of the day’s activity. This gave the business a relatively high price
earnings ratio of 19 times (based on its forecast 2009 earnings). This might be justified if
the company was able to continue to grow the business by exploiting the type of newer
investors that had been largely ignored by existing financial services companies.
Key terms
List This refers to the companies whose shares are quoted on the Main List of the UK Exchange.
Companies who want to be listed must meet the very exacting criteria which are contained in
the Stock Exchange’s ‘Yellow Book’. These criteria include the number of shares that have to be
in the public’s hands ahead of trading in the shares, the company’s trading and financial history
and the suitability of the board of directors. The Official List is intended for medium or large
companies as there are high initial launch costs in addition to significant annual charges.
Initial public offer (IPO) When we examine any major stock market it is useful to split it into
two aspects. The first is to see it as a primary capital market which enables companies to raise
new share capital. In contrast a stock market must serve a vital function as a secondary market
providing liquidity to the existing shares which can be traded. In this way existing shareholders
can sell some or all of their holdings to new investors who want to buy a stake in the business.
An IPO refers to the situation where a company first sells its shares by listing on the stock
exchange. This gives it a much wider access to increase its shareholder base. In addition, it pro-
vides much great liquidity in terms of the trading of the shares in the company. Companies
considering a new IPO will appoint an investment bank to manage the process. They will meet
the company and be heavily involved in valuing the shares, preparing a prospectus and getting
investors interested in the new issue. The investment bank will be very well rewarded for this
work with substantial fees often being paid to ensure a successful IPO.
Unit trusts If you pick up the Companies and Markets section of the Financial Times and go to
the section called ‘Managed Funds Service’, you will see page after page of data relating to
investments offered to private investors by professional fund managers. These will include a vast
number of unit trusts which are a very important form of collective investment. They allow
private investors to get exposure to a range of different sectors including the standard equity
111
funds, bond funds, money market funds and various property funds. The attraction of unit trusts
is that they allow fairly small investors to spread their risk across a more diversified portfolio.
All unit trusts are called ‘open-ended’, which means that the ultimate size of the fund is deter-
mined by the amount of cash that investors want to put in it. As more money flows in, the fund
just keeps growing in size, which allows more money to be invested in the designated markets.
The basic principles can be easily explained with a simple example:
A new unit trust ‘KB special opportunities fund’ is created. It has a clear investment
strategy as it is looking to invest in the UK equity market with a strong bias towards
smaller companies. Nearly all unit trusts actually have two prices – an offer price and
a bid price, with a significant spread between them. The offer price is the price that a
new investor must pay to buy a unit. The bid price is the price that an investor receives
when selling a unit. As the spread between the buying price and the selling price of
each unit might easily be as much as 5 per cent, you can see the need to view these
investments as being relatively long term. If they are sold very soon after purchase,
the investor stands to lose this initial spread even if the actual units are still at the same
price.
The ultimate price of the units will depend on the performance of the fund
manager. If they are successful the value of the fund will grow and so each unit will
appreciate in value.
Price–earnings ratio (PE ratio) The PE ratio is calculated by taking the market share price and
dividing it by the company’s earnings per share.
Institutional investors These are the large pension funds and insurance companies that are the
key investors in financial markets. They look to invest in long-term assets to match their long-
term liabilities (paying out pensions). These investors have flourished in recent years due to the
greater wealth of the private sector. In contrast the private clients refer to the individuals who
invest on their own behalf.

1. The FT article quotes a range of 140–160 p as an indicative range for the new IPO in
Hargreaves Lansdown. What factors determined the final price for this new issue?
2. At the end of the first day’s trading the PE ratio for this issue was around 19. How does
this compare to other similar companies listed on the UK stock market?
3. What is the main advantage for investors in buying unit trusts through a firm like
Hargreaves Lansdown rather than direct from the unit trust fund?
You will need the Companies and Markets section of the Financial Times. Go to the Managed
Funds Service. This is normally about halfway through the Companies and Markets section.
112
Look at the section covering the fund manager Artemis:

1. What is the selling price of a unit in the Artemis Capital Fund?
2. What is the buying price of a unit in the same fund?
3. You are nervous about the outlook for the UK stock market, which Artemis unit trust 6
funds might you look to invest in?
EQUITY FINANCE
I Go to the web
Go the official website of Artemis: www.artemisonline.co.uk.
Find the section called ‘filmclub’.
What are the latest views of the main fund managers in relation to the investment outlook?
I Research
Arnold, G. (2004) The Financial Times Guide to Investing, Harlow, UK: FT Prentice Hall. You
should look especially at Chapter 5, pages 72–80 to get more information about unit trusts.
You should look at pp. 370–75 to find out more about price–earnings ratio.
should look at pp. 584–5 to find out more about price–earnings ratio.
You should look at Chapter 7. The offer for sale process is set out on pp. 283–5.
The topic of new share issues is covered in Chapter 23.
Edition. There is a discussion of the process of ‘going public’ on p. 338.
Financial Times. You should consult Chapter 8 for some coverage on new share issues.
Hall. You should look at Chapter 2, pp. 30–31 to see a useful discussion of the role of the
London Stock Exchange.
FT Prentice Hall. You should look at Chapter 4, pp. 96–102 on the listing process.
113
Good value at Sainsbury’s?

It is very common for the Lex column to consider the current stock market valuation of a
company. Several of the valuation techniques commonly set out in corporate finance text-
books will be applied. In this article the Sainsbury’s market share price (560 p) is compared
with a more realistic value of just 400 p/share based on a discounted cash flow approach.
Lex argues that the higher price can only be justified by the assumption that there are
bidders in the wings who will be prepared to offer significantly more than this funda-
mental valuation. It concludes that the current business structure of Sainsbury’s does not
allow it to realise the full value of the company’s extensive property assets.
Valuing Sainsbury’s
Lex column
The numbers were almost beside the an appropriate earnings multiple results
point. Even so, J Sainsbury’s 2006 in a yet lower price.
results, released on Wednesday, helped to Although there will be upgrades fol-
clarify the market’s position on the UK’s lowing Wednesday’s encouraging results,
third biggest food retailer. There was operating margins are still well below
hope that the company’s management Sainsbury’s rivals. At best, margins are
might at least hint at property sales, expected to improve from 2.5 per cent
especially having just let a potential 585 p today to about 4 per cent by 2010. But
per share private equity bid pass it by. Tesco’s margin is already in excess of
But Sainsbury, quite rightly, reiterated 6 per cent. This is the crux of Sainsbury’s
the case for keeping control of its prop- problem. It has to improve margins while
erty assets and its shares closed also lowering prices and boosting top-line
unchanged on the day. At least this growth. But even assuming Sainsbury’s
demonstrates an efficient market: upgraded sales targets can be met, Tesco
whether or not a retailer owns its sites is growing faster, further widening its
should not alter its value beyond some scale advantage.
minor financial tweaking. No wonder investors’ hopes turn to
A share price of 560 p shows that Sainsbury’s £8.6 bn property portfolio –
investors are fully expecting another equivalent, excluding debt, to about 470 p
approach. Few analysts’ discounted cash per share. Sure, it is possible for a third
flow valuations are above 400 p. Mostly, party to extract this value. But given the
this is owing to a low terminal growth interdependence of property and retail
rate as Sainsbury has no exposure to operations, this cannot be achieved
emerging markets and is underweight in without damaging the operating company
faster-growing non-food retail. Applying – perhaps irrevocably.
114
Article 21 Valuing Sainsbury’s
I The analysis
In this article the Lex column reflects on the correct valuation of Sainsbury’s shares. Earlier
in the year there had been a sharp rise in their share price following a proposed move by
a private equity bidder to buy the company. At this time David Sainsbury, the single largest
shareholder, was thought to have ruled out such bids at least until they hit the 600 p level.
6
In order to understand these bids it is important to grasp the concept that private
EQUITY FINANCE
equity firms are actively looking for companies with strong cash flow and key assets which
are not being fully exploited by the existing management team. Sainsbury’s meets both
these criteria with strong earnings from its stores and an impressive portfolio of property
assets, which are a big attraction to private equity companies because they can see their
potential. It is likely that any bidder would look to sell a large proportion of Sainsbury’s
stores, and then lease them back. Such a move would generate a massive amount of cash
for a private equity firm. When the previous bid was made, the existing managers stated
that these property assets would remain part of the current business. As Lex says ‘At least
this demonstrates an efficient market: whether or not a retailer owns its sites should not
alter its value beyond some minor financial tweaking’.
The column goes on to argue that the fact the share price is still at 560 p firmly sug-
gests that the market is still pricing in another bid approach. The normal discounted cash
flow valuation would arrive at a share price nearer to 400 p. These techniques are based
on the following key financial variables: the company’s cash flows, the discount factor and,
crucially, the growth rate. This latter factor is assumed to be much lower for Sainsbury’s
than its main rival Tesco which has far more exposure to both high-growth emerging
markets (in Eastern European and South-East Asia) and also non-food retail products
(clothes, electrical goods, etc.).
The article finally looks at ‘Wednesday’s encouraging results’ which it expects to prompt
some brokers to upgrade their share price valuations. However, it still compares
unfavourably the margins achieved by Tesco (6 per cent) and the much more modest 4
per cent (at best) for Sainsbury’s. In conclusion, Lex claims that Sainsbury’s £8.6 billion
property assets, excluding debt, might be worth some 470 p per share. While it is poss-
ible that an outside bidder could achieve this value from the property assets, it would be
less straightforward for Sainsbury’s with its current structure to exploit this possibility. As
the article points out, if Sainsbury’s was to sell all its retail outlets, this would change the
whole nature of the business and perhaps cause irreversible damage.
I Key terms
Private equity This term is used to describe the activities of a group of companies that invest
in businesses that are already privately owned or ones that the buyers intend to remove from
the stock market as soon as possible. See Article 24 for a full explanation.
Property assets Accountants like to distinguish between current assets (these are very short
term and will last less than a year) and fixed assets (longer term and will last more than a year).
The key fixed asset for Sainsbury’s will be their vast property portfolio. This will include many
high street stores as well as distribution warehouses.
115
Sale and lease back This is a very common transaction used by companies that want to extract
the value of any significant assets. A company can sell its property (in this case the stores owned
by Sainsbury’s) and then lease them right back from the buyer (normally a financial institution)
in the same transaction. This enables the owner to get the cash from the sale but at the same
time still use the property to carry out their business. The financial institution that buys the
property is guaranteed a long-term income from the leases on the property.
Efficient market This refers to the way that share prices react to new information. A stock
market is efficient if it reacts quickly and accurately to a new market-sensitive announcement.
So, if a company announces a surprise increase in dividends, its share price should rise immedi-
ately. If instead it reacts very slowly or indeed even falls in price, the share price will be highly
inefficient. There are different levels of share price efficiency. You should read Arnold, Corporate
Financial Management, FT Prentice Hall, p. 691 to learn more about this topic.
Discounted cash flow valuation Put very simply, this is where we take the future cash flows
which will be earned by a company and multiply them by an appropriate discount factor to get
their present value. This is a widely used technique to place a value on the share price of a par-
ticular company.
Emerging markets This refers to the financial markets of developing nations. In general, these
markets have not been trading for long and as a result they are seen as being more risky than
traditional financial markets.
Upgrades The investment banks employ analysts who research the prospects for a company
and then place a target value for their share price. When the prospects for a company improve,
these analysts will raise their forecasts. This is called a ‘profit upgrade’. It might follow a new
investment opportunity or a change in the company’s business strategy.
Margins This is the difference between the company’s average selling price for its goods or
services and the costs that are required to produce them.

1. Why might a private equity bidder value Sainsbury’s at 585 p compared to a value of
just 400 p based on a discounted cash flow technique?
2. What is meant by the term ‘sale and lease back’ in the context of corporate finance
deals?
3. What data would you need to calculate a valuation of Sainsbury plc using the
discounted cash flow method?
4. Why is Tesco plc able to achieve a much higher margin and growth rate than Sainsbury
plc?
You will need a copy of the Companies and Markets section of the Financial Times. Go to
the London Share Price Service. Locate the Retailers section.
116
Answer the following questions.

1. What are the current share prices of Sainsbury plc and Tesco plc?
2. Compare the volatility of these two share prices in the last year.
Hint: Look at the high/low data.
3. Compare the P/E ratios of these two companies. What do these figures say about the 6
current stock market valuation of them both?
EQUITY FINANCE
I Research
You should look at Chapter 10. The dividend growth model starts on p. 372.
should especially look at Chapter 20. The dividend growth model starts on p. 756.
You should look at Chapter 12. You will see a very good introduction to the valuation of shares
on pages 501–12. The dividend valuation method is explained on pp. 508–9.
The dividend discount model is set out on pp. 249–56.
Edition. There is an introduction to the dividend valuation model starting on p. 512.
Financial Times. There is a good guide to price earnings ratios on pp. 60–61.
Hall. You should look at Chapter 12. The dividend growth model is on p. 297.
FT Prentice Hall. You should look at pp. 326–7 to see the dividend growth model explained.
117
As Woolworths died we try speed-dating

for the last time!
On the day that Woolworths finally died I could not help but feel slightly nostalgic recalling
my own childhood when a definite highlight would be the occasional visit to buy sweets
from their garish ‘pick and mix’ counters. On the evening of their demise I was attending
my youngest daughter’s final parents’ evening at the school that she had attended for the
previous seven years. At one point in the evening as we were waiting to see her French
teacher, I took the chance to stand back and look around the large hall for one last time.
As I did so I could not help but wonder at what point the traditional parents’ evening had
given way to what now looked more like a speed-dating event. For those of you who have
yet to endure such occasions these days the parents move from teacher to teacher,
spending no more than two to three minutes with each one. This time allocation allows
you to do little more than exchange a few pleasantries before the teacher anxiously looks
to move you on so that they can meet the next in line.
If the school system was going through a period of change, the collapse of Woolworths
was a clear sign that the credit crisis was also leading to major change in the look of the
UK high street. Almost every new day bought fresh headlines of another store in severe
financial difficulty. It became clear that after the boom years we were now heading for the
inevitable bust. The shortage of available bank finance led to many casualties including
chains like Whittards, Zavvi, the Pier and the furniture giant MFI. It became clear that the
UK high street had grown too fat in the good years as consumers had gone on a debt-
fuelled spending spree. In the more austere times caution had set in and high street sales
were collapsing. The damage impacted on the whole range of goods from luxury items
sold by chains like Mulberry and Chanel all the way to the more value-focused retailers. At
this bottom end of the high street were Woolworths who had long been in difficulties but
now had finally collapsed under a mountain of debt. The loss of one of the oldest UK store
groups sent shock waves through the rest of the high street. For many the demise of
Woolies removed one more pillar from their fading childhood memories.
Woolies investor opposes sale

Tom Braithwaite
Woolworths’ biggest shareholder yes- Shares in Woolworths fell to their

terday criticised talks between the lowest-ever level after the company
retailer and Hilco UK, the retail restruc- acknowledged it was in talks to sell its
turing company, arguing the group’s 800-store retail division. Hilco UK,
stores were worth much more than the which invests in troubled companies,
nominal price under discussion. has indicated it would pay a £1 for the
118
Article 22 Woolies investor opposes sale
stores and assume part of the group’s Mr Naghshineh said Steve Johnson, the
debt. new chief executive, should be given time
Ardeshir Naghshineh, the Iranian to turn the stores round and urged the
developer who owns 10.2 per cent of board not to talk to Hilco.
Woolworths, said the proposed deal was ‘Obviously there’s an alternative deal’,
unacceptable. said Mr Naghshineh, who declined to say 6
‘It’s ridiculous to sell the whole retail whether he would be part of a rival bid.
EQUITY FINANCE
division for £1’, said Mr Naghshineh, As the exclusive talks continue, Hilco
whose Targetfollow company owns Centre UK is offering to take on part of
Point tower in central London. Woolworths’ debt and all the leases,
‘We are obviously experienced in prop- although some of the onerous leases could
erty’, he said. ‘We know that it’s worth be shed if the potential bidder opts for a
hundreds of millions of pounds. I know pre-pack administration.
stores at the moment where landlords are The pension fund deficit and much of
prepared to give millions of pounds in pre- the debt would remain with the rump of
miums to get Woolworths out.’ the company, which includes a profitable
Shares in Woolworths plunged 38.3 per wholesale distribution business and a
cent, or 1.46 p, to 2.35 p after being sus- DVD publishing joint venture with the
pended yesterday morning to give the BBC.
company time to release a statement While Mr Naghshineh’s objections will
announcing the talks. figure in the board’s discussions, directors
Some analysts have long believed the believe that the deal may be the best to
retail division is worth nothing, weighed protect dwindling shareholder value and
down by onerous leases, heavy debt and prevent the whole business from falling
increased competition from supermarkets into the hands of creditors.
and internet rivals.
The analysis
In the wake of the credit crunch a number of UK retailers came under severe pressure. In
truth, one of the biggest casualties was Woolworths who had been one of the iconic
names on the UK high street. Their troubles came to a head in late November 2008 when
the company announced that trading in the retailer’s shares had been suspended as they
continued with talks in an attempt to save the business. In a statement the company said
that it was having discussions with a view to sell some of its 840 stores. The article that I
have included here is from the previous week when the FT ran a story indicating that
Woolworths could be sold for just £1 to Hilco UK. This proposed sale was fiercely opposed
by Woolworths’ largest shareholder, Ardeshir Naghshineh, who owned 10.2 of the
company’s shares. He felt that the proposed deal was a massive undervaluation of the busi-
ness.
The Woolworths business was dominated by its retail division with some 800 stores
employing around 30 000 people in the UK. Despite its significant presence on the high
street, many felt that this part of the company was worthless. This situation was due to a
combination of severe business and financial risk.
119
I How did business risk impact on Woolies?

This refers to the general risk that can impact on a company’s cash flow or profitability.
It could be caused by general economic conditions (consumer spending, level of
interest rates, etc.) as well as more specific company factors (such as changes in key
staff or strike action by employees). In the case of Woolworths the company showed
all the signs of being hit by severe business risk. Much has changed within the retail
sector over the past few years and Woolworths ended up by losing out to the many
Internet retailers which had taken over a substantial share of the market. This led many
to wonder what exactly the purpose of Woolworths was.
I How did financial risk impact on Woolies?
This is the risk that applies to any company that has debt finance (see Topic 4) as a sig-
nificant part of its capital structure. It refers to the possibility that a company will face
financial distress due to the inability to pay either the annual interest or the principal
on an outstanding debt issue. In the case of Woolworths the business had some
£385 m of debt that had to be financed in very difficult market conditions.
The only upside for Woolworths was that it did have two profitable parts of the busi-
ness. These were a wholesale distribution business and a DVD publishing business
which was a joint venture with the BBC. At the time of the article the sale of these busi-
nesses seemed to be the only way to save the company and to offer any financial value
to the company’s shareholders. In the end the company was formally taken into
administration on the 6 December 2008 with debts of £385 m. Sadly a buyer could
not be found and as a result its stores were shut and thousands of their employees
joined the growing band of the unemployed.
I Key terms
Nominal price This refers to the very low price that was being offered by Hilco UK who were
looking to buy Woolworths.
Leases This is a very common transaction used by companies that want to extract the value of
any significant assets. A company can sell its property (in this case the stores owned by
Woolworths) and then lease them right back from the buyer (normally a financial institution) in
the same transaction. This enables the owner to get the cash from the sale, but at the same time
they can still use the property to carry out their business. The financial institution that buys the
property is guaranteed a long-term income from the leases on the property.
Rival bid This is where there is a corporate takeover in progress and a new bidder emerges to
challenge the current company that is looking to buy a business. In this case the bidder would
be a rival to Hilco UK who hoped to buy Woolworths for just £1.
Pension fund deficit This refers to the crisis that affected companies in the wake of the
financial market weakness of 2008. This led to many companies having inadequate financial
provision in order to cover the liabilities to their employees in terms of future pension payments.
As a result many companies were being forced to divert some of their profits in order to re-
finance the pension funds.
120

1. In the context of this article explain what corporate financiers mean when they use the
terms ‘financial’ and ‘business’ risk.
2. What is the dividend valuation model and how is it used to place a value on a
company’s shares? Would the use of this model help to explain why a major UK retailer 6
with over 800 high street stores was being offered for sale to Hilco UK for just £1?
EQUITY FINANCE
3. Why did Woolworths’ largest shareholder believe that the proposed deal to sell the
business for just £1 to Hilco UK was a bad deal?
4. What were the main factors that had led to the problems that Woolworths was expe-
riencing at this time?
5. A week later shares in Woolworths were once again suspended on the London Stock
Exchange. Explain what this means in practice and why it is important for companies
to be allowed to do this.
6. Did the performance of Woolworths’ share price suggest that they were behaving in a
way that was compatible with at least the semi-strong level of stock market efficiency?
You will need a copy of the Companies and Markets section of the Financial Times.
Go to the London Share Price Service.
Find the latest price–earnings (P/E) ratios for the seven UK retailers listed below:
P/E ratios What are they now?

(October 2008)
Clinton Cards 2.4
Carphone Warehouse 10.2
Debenhams 4.2
Marks and Spencer 4.6
Tesco 13.3
J Sainsbury 14.2
Woolworths 4.8
You are required to explain what a P/E ratio is and show how it can be used to place
a value on a company.
In addition you should try to explain the change in the levels of the P/E ratios from
October 2008 to the present.
I Research
You should look at Chapter 11. Business and financial risk are discussed on p. 396.
121
should especially look at Chapter 13. Business risk is defined on p. 527.
You should look at Chapter 8. You will find a discussion of the impact of high gearing on
company performance.
The concept of risky debt is covered on p. 710.
Edition. There is a section on changes in risk on p. 358.
Financial Times. There is a good guide to financial/business risk on p. 297.
Hall. You should look at Chapter 7. The concepts of business and financial risk are explained on
p. 163.
FT Prentice Hall. You should look at p. 192 for a definition of financial risk.

122
Topic 7
Stock market efficiency
Like most university lecturers I am increasingly being encouraged to make use of various
web-based platforms to communicate with my ever-growing numbers of students. The
main vehicle at Kingston is something called StudySpace which enables the students to
access course documents as well as join in various activities like discussion boards and
class tests. It also has a very useful facility which allows me to make announcements to
all the students registered on the course. Recently I used this device to demonstrate a
key theory of corporate finance in action.
This is how it worked:
I Step 1: I announced that the lecture in a week’s time would be focusing on a key
topic that they should expect to see heavily tested in their end of course exam. I
stressed to them that this was an important session and that they should make every
effort to attend.
I Step 2: I followed this up with a short individual e-mail to each student with a similar
message.
I Step 3: A week later I walked into the lecture theatre for the year 2 Finance lecture
and I could not help smiling as I looked around the room. After a quick headcount it
was clear that the attendance was around 110 compared to the usual 70–80
students.
My pleasure came from the realisation that not only had my message convinced a
significant number of students to get up early to come and attend this 9 a.m. lecture,
but in addition I could now show them how their behaviour would be a perfect example
of what today’s topic was all about. That morning I was going to introduce them to
stock market efficiency.
Every day at the back of the Financial Times you will see in the Markets section the daily
changes in individual share prices. For example, Scottish and Newcastle dipped 1.7 per
cent as takeover hopes faded or Unilever rose 1.6 per cent as traders took the view that
it might be the next company to be targeted by an activist shareholder. Both of these
show how company share prices react to relevant news stories or possibly just to
rumours. This takes us into the area of share price efficiency as we see whether the share
prices react quickly and correctly to these pieces of information.
In the context of stock markets the term ‘efficiency’ is used to define the situation where
any new information about a company’s prospects is quickly and accurately reflected in its
share price. For example, if a company cancels an expected final dividend to shareholders,
you would expect to see its share price fall immediately as it absorbs this piece of bad
news. The share price change should be rapid and logical. If it takes some time for the
share price to react to any published information, then the markets are deemed to be
highly inefficient. The message of stock market efficiency is that it should not be possible
for investors to make money by making their investment decisions on the basis of infor-
mation that is already in the public domain.
The creation of the efficient markets theory (EMT) in the mid-1960s can be traced back
to the work of Eugene Fama, the well-respected US economist, who was widely touted
as a possible Nobel Prize winner in 2008. Indeed, but for the financial meltdown in
existence at that time he would almost certainly have been the winner. The EMT actually
defines three different levels of share price efficiency:
1. Weak-form efficiency where current share prices fully reflect all past share prices. This
means that you should not be able to trade successfully on the basis of using a chart
of previous share prices to try to predict the future price movements.
2. Semi-strong efficiency builds on the first level by adding the condition that share
prices must now fully reflect all published information. This will include important
news stories like profits figures, new investments and dividend decisions.
3. Finally we have strong efficiency, which now adds the condition that share prices also
reflect all inside information. This covers any important information that is privately
held by insiders like important staff within the company. Such a position would mean
that even these people could not use their inside information to make abnormal
profits by trading in their company’s shares.
While few people would argue that most share prices are strongly efficient, it is widely
accepted that they do meet the conditions necessary for semi-strong efficiency. This has
important implications for investors. It is especially important that they should note that
it is not normally possible to use publicly available information to make abnormal profits
by trading the stock market. This means that they might do just as well by investing in a
broad range of shares rather than by trying to select a portfolio of stocks that they
believe will outperform the market. This has contributed to the growth in so-called
‘indexed funds’ where investment managers purchase a group of stocks that are
designed to be a close match to a particular stock market index. These indexed funds
have the major attraction of relatively low charges to the fund holders.
So, how did my example of encouraging wider attendance of students at my lecture

demonstrate the EMT in action? It is simple, really. By announcing the special
importance of this lecture to all students and strongly hinting that it would be examined
in the summer, I was hoping to see the students reacting in a logical manner. They did
this by turning up in large numbers eager to learn all about the EMT. As a result, in the
summer exam no student should be able to achieve an abnormal mark simply by
focusing on this topic, as the public announcement of the significance of the lecture
meant that virtually all students will have the information needed to answer this
question well. It is good to see that my students are logical and rational. In fact they are
at the very least semi-strongly efficient students!
The following article is analysed in this section:
124
Article 23
Stock splits: time to query decades of dogma
This article addresses the following issues:

I nominal share price; 7
I stock dividends;
STOCK MARKET EFFICIENCY

I stock spread;
I financial intermediaries.
125
Company shares split down the middle

In Midsomer Murders, the long-running ITV crime show, they seem to need at least five
dead bodies per episode to satisfy their viewers. If the writers ever get tired with the usual
poisonings, shootings or vicious knife attacks, I can suggest a rather more sophisticated
way of bumping off the next victim. This is how it might work. The person involved is a
retired colonel living in the country. He has a known heart condition and has just recently
invested his entire fortune in the shares of Shadowlands plc. As students of corporate
finance will know, it is never a good idea to put ‘all your eggs in one basket’.
One morning as he reads the Financial Times over breakfast he suddenly sees that his
shares have halved in price overnight. His face turns white and he collapses in agonised
pain head first into his bowl of cornflakes. What starts out as a routine death soon becomes
a murder enquiry as rumours surface of foul play? After weeks of unsuccessful investi-
gations the police call in the Professor of Finance at Badgers Drift University. With
surprising efficiency for an academic he solves the case and identifies the murderer.
It turns out that the colonel’s nephew is in fact the Chief Finance Officer at
Shadowlands plc and he had just organised a 2 for 1 stock split for the company’s shares
that had just hit £10 in the market. As a result the shares fell to £5 overnight. Since the
colonel did not understand this transaction, he failed to realise that he in fact owned twice
as many shares as he did previously. So what was the nephew’s motive? Simple: he was
the only surviving relative of the colonel and he stood to inherit his fortune including a
country estate that he had always coveted.
Article 23 Financial Times, 8 April 2007 FT
Stock splits: time to query decades of

dogma
John Authers*
This is a holy juncture. Christians are cel- stock split involves replacing every out-
ebrating Easter while Jews are standing share with two, and making no
celebrating Passover. These festivals other changes. It is a complicated oper-
strengthen and reassert faith, but they do ation (although not wildly expensive: it
so in large part by questioning it. generally costs up to $1 m for a large
At a less profound level, self-questioning company), whose only effect is to halve
and disciplined doubt can be good for an the nominal price of the shares.
investment portfolio, not just for the soul. So The habit is ingrained. General
let’s take this opportunity to question one Electric’s share price at the end of 1935
time-honoured ritual of equity investing: was $38.25. Exactly 70 years later, it was
stock splits. What is the point of them? $35.05. According to research by a group
Stock splits are meant to keep a share of academics from the University of
price at a manageable level. A two-for-one California at Los Angeles, Cornell
126
Article 23 Stock splits: time to query decades of dogma
University and the University of Are there good reasons for this? None
Chicago,** GE would by this point have stand up to examination. One is that
traded at $10 094.40, had it never paid there might be an ‘optimal’ trading range,
stock dividends or split its stock. at which individual investors can afford to
I once interviewed a nonagenarian US buy a round number of shares. But this
investor, who had started his portfolio should logically at least have risen with 7
during the Depression. He tallied the inflation, so that average nominal prices

success of his investments by the number of now would be ten times their level of the
shares he had 60 years later, rather than by 1930s. And in any case, individuals mostly
their value – so much was it taken for now hold stocks through mutual funds,
granted that companies would split their which don’t find high share prices a deter-
stock to keep the nominal price at about $40. rent.
No constituent of the Dow Jones Another possibility is that there is an
Industrial Average has a share price of effective minimum ratio between the
less than $19, or more than $95. ‘tick’ size, or spread between bid and offer
In the UK, people like the nominal price prices, and the share price. Below a
of their shares to be even lower. Prices are certain ratio, on this argument, nobody
quoted in pence, not pounds. No con- will be prepared to make a market in the
stituent of the FTSE-100 has a share price stock. This will keep the share price down.
of more than 2680 p, or less than 310 p. The problem here, the researchers
There are obvious disadvantages. Splits point out, is that exchanges have intro-
get in the way of comparisons of share duced decimalisation in recent years, in
price performance over time (although place of fractions. This helped to reduce
decent data providers can overcome this). the average tick size from $0.125 per
Sometimes they are self-defeating. share to about $0.01 over the last decade.
Lucent Technologies probably wished it But instead of falling by more than 90 per
had not bothered to keep its share price at cent, as this theory would predict, average
a ‘manageable’ level after it was caught share prices stayed the same.
up in the collapse of the internet bubble. A final argument is that a low share
For years, until its merger with Alcatel of price, despite the attendant costs, signals
France last year, its share price stood at to investors that a company is of high
about $2. It almost always had the highest quality. But a low share price can be
volume of shares traded on the New York embarrassing. And the researchers found
Stock Exchange. splits tend to come just as earnings have
This is important, because stock peaked – not a time when companies need
exchanges and other intermediaries to send out positive signals.
charge fees based on the number of So has anybody had the nerve to go
shares traded, rather than on the amount against the orthodoxy? They have, and
of money that changes hands. So splitting their identity is revealing. Warren
stock increases costs for investors. The Buffett, the world’s most successful
researchers from Cornell and elsewhere investor, has never seen the point of stock
found that GE investors would have splits. A share of Berkshire Hathaway, his
saved 99 per cent in brokerage com- main investment vehicle, will cost you
missions if the company had not split its $100 000. This has not harmed demand
stock. About 5 bn GE shares traded in for the stock over the long term. Beyond
2005, so this is equivalent, they say, to the Buffett empire, the two highest share
about $100 m – big money, even for big prices belong to the Chicago Mercantile
investors. Exchange (which has been as high as
127
$593) and Google (which has been as high split their stock, and investors should not
as $513), the two most successful stock reward them when they do.
market debutants of this century. Neither
has felt any need to bring its share price Notes
down to a lower level, and neither has
*john.authers@ft.com
been punished for this by investors.
**Working paper: ‘The Nominal Price Puzzle’, by
So this is one case where questioning
Shlomo Bernatzi, Roni Michaely, Richard H. Thaler
faith leads to a surprising result. Despite and William C. Weld, University of California at Los
a century of dogma, companies should not Angeles.
I The analysis
Liquidity is a very desirable characteristic for a financial market product. When it comes to
company shares there is always a concern that once it hits a very high market share price
this will impact negatively on its tradability. As the Financial Times article says ‘Stock splits
are meant to keep a share price at a manageable level’. So how does it work? It is easiest
to understand with an example. Suppose a company’s share price reaches £20. The
finance team at the company might start to worry that this ‘heavy’ share price will inhibit
trading the shares. So they opt for a 2 for 1 stock split. This means that every existing share
will now be converted into two shares. However, as a result of the split each share is now
worth half of its previous value, i.e. £10. Simply put, if I were to replace each £20 note in
your wallet with two £10 notes, this would represent the outcome of a share split. You
would have the same amount of money in your wallet, but in the form of more notes.
The Financial Times article uses the example of General Electric (GE) share price to illus-
trate stock splits in practice. So, their share price was $38.25 in 1935 and 70 years later it
is almost exactly the same at $38.05. The article quotes some research from the University
of California at Los Angeles to say that ‘GE would by this point have traded at $10 094.40,
had it never paid stock dividends or split its stock’. So how widespread is this practice? The
Financial Times article states that ‘No constituent of the Dow Jones Industrial Average has
a share price of less than $19, or more than $95’. If you look at the London Share Price
Service in the Financial Times, you will see very few FTSE 100 shares with a price of more
than £20.
There are some clear disadvantages in share splits. First, they make price comparisons
over time much more difficult. You must always first make the relevant adjustments to the
share prices to take full account of any share splits. In addition, the share splits raise dealing
costs because these fees are based on the number of shares traded rather than their value.
So how can we explain the great enthusiasm for share splits? One possibility is that there
is some ideal range for the level of market share prices, and if you were to go outside this
it would discourage private investors buying a company’s shares. The search for this
enhanced liquidity must always be tempered by the concern about raising dealing costs.
Second, the Financial Times article argues that ‘there is an effective ‘tick’ size, or spread
between the bid and offer prices and the share price. Below a certain ratio, on this argu-
ment, nobody will be prepared to make a market in the stock. This will keep the share
price down’. This is refuted by the claim that since decimalisation was introduced into
128
share prices the average tick price has declined significantly. However, despite this average
share prices have remained static and not fallen as this theory would have predicted.
Third, there is the argument that share splits are a clear signal from the company to
investors that prospects are favourable and that a further sharp rise in the share price is
expected. This article challenges the claim by stating that most share splits actually take
place when compare profitability is at a peak rather than a low. This suggests that any posi- 7
tive signal suggested by a company’s share split is often misleading.

The article ends by citing one share that has never been split. Warren Buffet, a well
known international investor, does not support the advantages of stock splits. He just lets
his share price rise so that one share in his investment company, Berkshire Hathaway, costs
around about $100 000. I had better start saving to buy one of those, or perhaps it is time
for me to pay a visit to my dear old Aunt Agatha who lives in the country!
I Key terms
Nominal share price This is merely a value given to a company’s share which is only used for
accounting purposes. Unlike the par value of a bond it has no direct link to the market price.
Nonagenarian This refers to a person who is aged between 90 and 99 years old.
Stock dividends This is an alternative to an ordinary cash dividend. In this case the dividend is
paid in the form of extra shares. For example, a 5 per cent stock dividend means that each
shareholder gets an extra five shares for every 100 they own.
Intermediaries These are financial institutions that act as a middleman between those cash
surplus units in the economy (the lenders) and the cash deficit units in the economy (the bor-
rowers). Put simply, they enable people with money to meet people who need money.
Borrowers: Lenders:
Govts Pension Funds/Insurance Companies
Companies Banks
Individuals Individuals
Brokerage commissions If you wish to use the services of a stock broker in order to buy or sell
shares you must pay them fees. This ‘brokerage commission’ is normally a set percentage of the
total transaction or some kind of flat-rate charge.
Spread (tick size) In most financial markets if you ask a market maker for a price they will quote
both an ask price (buying price) and a bid price (selling price). The market maker makes a profit
by setting the ask price above the bid price. This means that they can sell the security for a higher
price than they buy it for. We call the difference between the ask and bid price the ‘spread’.
Suppose the ask price for a particular share is £14 and the bid price is £14.20 p, then
the ‘bid–ask spread’ is 20 p.
This can also be called the ‘tick’ size.
129

1. Explain what is meant by a two for one stock split.
2. What are the advantages and disadvantages to the company and its shareholders of
splitting the shares if the share price hits £20/share?
3. If a company decides to split their shares when they hit £10, what could this signal in
terms of the future prospects for the company?
You will need a copy of the Companies and Markets section of the Financial Times.
Go to the London Share Price Service.
Now find the Travel and Leisure and the Real Estate sections.
1. Calculate the average share price in each section.
2. Identify any shares in these sections that might be likely to see a ‘share split’ in the near
future.
I Research
You should look at pp. 225–31 to see the efficient market hypothesis discussed.
should look at pp. 563–7 to see the efficient market hypothesis discussed.
You should look at Chapter 7. The efficient market hypothesis is discussed on pp. 269–75.
The efficient markets theory is set out in Chapter 9. The key pages are 268–9.
Edition. The efficient market hypothesis is on p. 344.
Financial Times. There is a section on the efficient markets theory in Chapter 9.
Hall. You should look at Chapter 2 pp. 34–7.
FT Prentice Hall. You should look at Chapter 2, especially pp. 34–41 to see the efficient markets
hypothesis explained.

130
Topic 8
Private equity finance featuring
management buyouts
Sadly these days, in the world of finance and financial markets mainstream TV
programmes seldom provide a useful teaching resource. In the past I have used
programmes such as the BBC’s Money Programme and Channel 4’s Business Daily. The
nature of the former programme has significantly changed and the latter has
disappeared off our screens altogether. However, I do have some ageing videos of a BBC
series called The Adventurers which focused on the role of a venture capital company. It
showed us the business from the inside. When I last showed the programme to my
students, they thought that the dated clothes worn by the firms’ executives were highly
amusing. It was rather like watching the TV programme Life on Mars and seeing just how
quickly fashions and peoples’ attitudes change. In recent years I have used the Dragon’s
Den series. While it is far from perfect, it does give some insight into this topic. You do
get to see what the Dragons look for before they are willing to put their own cash into a
new business. If nothing else it gives the students a well-earned break from having to
listen to me!
When I was working on the first edition of this book, private equity was a relatively new
finance topic that was starting to dominate the business headlines. This was in sharp
contrast to earlier years when this term had been used only occasionally in the context
of a few specialised areas like management buyouts or venture capital. However, in the
spring of 2007 the topic of private equity moved from the fringes of corporate finance
right into the mainstream. Even back then the shadows of the credit crisis were starting
to hover on the horizon, and all too soon they would fundamentally fracture the
confidence of financial markets, pushing the private equity sector right back into the
margins. The explanation for this change was quite simple. Whereas we had the perfect
financial conditions for these deals from early 2005 to the spring of 2007, since then the
picture has completely changed.
So what are the necessary conditions for these deals to prosper?

1. You need rising stock markets and immense confidence that this will continue. This is
required to encourage the people who will come in and buy the businesses.
2. You need the availability of cheap debt finance.
Most of these deals are reliant on large amounts of borrowed money to fund the
transactions. If this is too expensive or simply not available, they will not happen.
Before we move on to analyse the chosen articles in this section of the book, it might be
helpful to explain a few key concepts that are used in private equity and venture capital
Private equity finance featuring management buyouts
deals. In terms of corporate finance these activities often stem from the desire for a
company to divest itself of part of its business. This can be motivated by the need to
raise cash or simply to allow the company to focus on what they perceive as their core
operations.
We can identify four main forms of divestment activities:

1. Spin-offs. We use this term where a single part of a large company is being separated
off. This might be where this part of the business is no longer considered as a ‘core
activity ‘. In most cases the host company will retain an equity stake in this new busi-
ness. This process will often take the form of a demerger. At a later stage the demerged
business that was subject to the ‘spin-off ‘ might well be sold on to another company.
2. Sell-offs. In contrast, with a ‘sell-off ‘ a non-core part of a company is identified and
then sold for cash. This move can be justified when the price achieved results in a
clear financial gain for the company’s shareholders. For example, in February 2009 a
struggling ITV company raised £1m by selling its stake in a spectrum management
company. This deal was part of its programme of non-core assets disposal.
3. Management buyouts (MBOs). Put simply, this is where the existing senior man-
agers of a company offer to buy the whole company or a section of the business
from the current owners. A strongly related corporate activity is known as a manage-
ment buy-in (MBI). This is similar to a MBO but is used where the managers of the
business being sold lack the necessary skills to be able to run the enterprise indepen-
dently of the parent company. So, in this case there will be a new team of managers,
from outside the company, who buy a controlling stake in the business. In the case of
a MBI the managers must have no previous direct connection to the target company.
4. Leveraged buy-out (LBO). In this case the use of the term LBO suggests that the
MBO (MBI) is almost entirely financed by borrowed money. To be honest the vast
majority of such deals will fall into this category as the managers will often find it
very difficult to find sufficient equity finance.
I Why do these deals work in practice?
Whatever the precise label attached to the deals, there is little doubt that many of
these corporate activities have been highly successful in practice. It is generally
recognised that this has sometimes been because part of the business was sold too
cheaply by the parent company. However, in many cases the explanation might be a
little more complex; it can be due to a massive increase in the managers’ motivation
when they become the owners. You should not find this too surprising. If you know
anyone who runs their own business just think how much harder they work com-
pared to those people are employed by a company.
I The financing of MBOs.
A key issue with MBO-related transactions is the complex financing required to get
these deals done. Generally speaking, the managers can only invest a small amount
of the cash needed to buy the business. However, they are often able to gain a dis-
proportionate share of the equity. This is through the existence of so called ‘ratchet ‘
132
Private equity finance featuring management buyouts
deals where they are given more equity in the business as a reward for meeting
various financial targets. The rest of the equity comes from venture capital firms who
are sometimes willing to take a significant stake in these companies. They can prefer
MBO-type ventures rather than ordinary new start-up businesses as they tend to be
less likely to fail. However, they will seek very high returns, often over 25 per cent pa.
In addition, they will also be keen to arrange early exits, ensuring that they can make 8
sufficient funds quickly and then move on to re-invest in other ventures.
PRIVATE EQUITY FINANCE FEATURING MANAGEMENT BUYOUTS

The rest of the finance will be through various forms of debt capital. As we saw in
the introduction to Topic 4, the highest-quality debt is termed ‘senior debt ‘ and this
will be obtained from commercial banks and investment banks. There might also be
some high-yield finance which ranks after senior debt in terms of any pay-outs in the
case of the business failing. This is sometimes called ‘mezzanine’ finance as it refers
to the layer of debt between the senior debt and the equity capital. The lenders will
normally maintain close contact with the new venture and they can place restrictive
covenants on future borrowings. These will prevent the company from issuing any
additional capital that pushes the existing debt holders further down the debt hier-
archy.
I have selected two articles to cover this topic. With the first, the aim is to provide a
detailed overview of the private equity industry as we examine the deal for Boots the
Chemist that hit the headlines in spring 2007. The second article takes a look at the
state of 3i, Europe’s biggest listed buy-out firm, as their share price tumbles and
confidence in the group hits rock bottom.
The following two articles are analysed in this section:
Article 24
Boots provides takeover acid test
Financial Times, 21–22 April 2007
Article 25
3i chief Yea quits following steep fall in shares
The articles address the following issues:

I private equity finance;
I internal rate of return;
I how private equity is financed;
I leveraged buyouts;
I impact of credit crunch on private equity;
I buyout deals;
I growth capital deals;
I early-stage venture capital deals;
I infrastructure deals.
133
Private equity firm fills its Boots

If during early 2007 you were searching most leading corporate finance textbooks for a
useful guide to private equity deals, you would have been very disappointed. At best you
might have got a few pages on management buyouts and venture capital. This all
changed with the corporate finance textbooks published from 2008 onwards, which
started to reflect the increased focus on private equity deals in the real world. This was a
part of finance that had moved from the fringes of corporate finance right into the main-
stream and the academic writers had to reflect this development.
Despite this increased prominence, it is clear that private equity remains one of the
most misunderstood concepts in corporate finance. The first article here examines the case
of the first ever UK FTSE 100 company to fall into the hands of a private equity financier.
It will explain the motivation behind the deal.
Article 24 Financial Times, 21/22 April 2007 FT
Boots provides takeover acid test

Chris Hughes, Tom Braithwaite and Andrew Taylor
Whether Alliance Boots falls to KKR or that would be off limits for a public
Terra Firma, any potential deal would company, such as extensive lay-offs that
become the acid test for private equity can plunge it temporarily into the red.
ownership of Britain’s largest and most The snag for the would-be owners of
iconic companies. Alliance Boots is the sheer size of this
The challenges are already apparent in deal. It would be Europe’s biggest ever
the heady price of about £11 a share that leveraged buy-out at close to £11 bn.
the bidders are willing to pay for the phar- Private equity executives admit that in
macist and retailer. And the more the transactions this big, they cannot behave
winner pays, the harder it will have to as though they are answerable only to
drive the company to make acceptable themselves. In November, Charles
returns. Sherwood, a partner at Permira, the UK’s
That would not be a problem in a largest buy-out firm, said: ‘The argument
smaller deal. An advantage of private that private equity is private may hold for
equity is the ability to take tough action smaller businesses. But when you own the
UK’s . . . largest private company . . .
Revenue by segment*
£m 2005 2006 people have different expectations on dis-
Retail 2,956 3,125 closure and that is understandable’.
Wholesale 4,343 4,388 Since then, a public furore has broken
Other commercial activities 44 47
Total revenue 7,343 7,560
out about private equity’s management
methods following February’s private
Retail outlets UK 2,586 equity approach for J Sainsbury, the
Retail outlets international 372
supermarket chain. The takeover failed
* Note: Pro forma six months to September, inclusive of intra-group revenue
amid resistance from members of the
Sources: Company; Thomson Datastream
Sainsbury family, some of whom had deep
134
Article 24 Boots provides takeover acid test
Alliance Boots
Share price (pence)
1200
Apr 20: HBOS joins the Terra Firma
consortium. Bid increased to £10.9bn
Apr 17: Terra Firma and Wellcome
table bid of £10.85bn
1100 8
Apr 10: Terra Firma and Wellcome

assess bid 1000
Mar 12: Board rejects KKR bid
Jul 31: Merger of Alliance Mar 9: Bid approach from
UniChem and Boots KKR and deputy chirman
Stefano Pessina 900
800
700
Aug 2006 2007 Apr
Source: FT Graphic: Mario Lendvai
suspicions about private equity owner- retary, has told Sir Nigel, KKR and
ship. Stefano Pessina, the executive deputy
For its part, KKR is going into this situ- chairman backing its bid, that the
ation with its eyes open. People familiar prospect of the deal would alarm staff and
with the firm say it insisted on putting the customers.
name of Dominic Murphy, the partner ‘Many such takeovers have hit staff and
leading the deal, on yesterday’s state- customers hard as the new owners seek to
ment. Others saw that as a risky make the biggest and quickest possible buck
disclosure. After all, Damon Buffini, the at the expense of the long term’, he said.
managing partner of Permira, has had to Paul Kenny, general secretary of the
endure unions dragging a camel to his GMB, which has been at the forefront of
church in protest at his wealth. the campaign against private equity,
There are already fears that while Sir asked the government to ensure that
Nigel Rudd, the chairman, has teased out a pharmacies in outlying areas would not be
great price for Alliance Boots’ share- closed to meet the cost of a highly lever-
holders, he has created a bigger problem aged buy-out.
for the current and retired work force. The He also attacked the existence of tax
worry is the new private equity owners will relief on interest payments, which will
need to cut costs and use excessive debt assist in the funding of any highly lever-
funding to make the deal’s maths add up. aged transaction. Taxpayers would be
Both KKR and Terra Firma are pre- subsidising any deal by £144 m, he said.
pared to go on the front foot on this ‘The union considers [the tax break] is the
occasion, angry at what they see as unfair motor that is driving this takeover of
criticism. Their rationale for paying a Boots and other household names.’
huge premium to the share price is that It certainly does no harm to the econ-
Alliance Boots is a growth opportunity: omics of a bid but even with the tax break,
pharmacies would be opened not closed; City analysts are sceptical that private
staff would be hired not fired. equity can make the numbers add up.
But trade unions have already waded Nick Bubb, analyst at Pali
in. Brendan Barber, TUC general sec- International, said in a note to clients that
135
KKR would struggle to generate an There is also a hope that liberalisation

internal rate of return of 20 per cent – the of pharmacy markets across Europe will
typical expectation of private equity transform the sector – and Alliance Boots
investors – if it paid its proposed £10.90 a could become a dominant international
share for the company. force.
This would require KKR to lift oper- Restrictions on pharmacy ownership –
ating margins from 4.5 per cent to 7.25 long abandoned in the UK – are thought
per cent over the next five years, judged likely to be lifted in most European coun-
‘very implausible given the pricing press- tries. And there is the hope that
ures in the business’. pharmacists will be given more power to
People familiar with each bid proposal prescribe medicines, drawing in patients
say neither plan involves cost-cutting and increasing footfall.
beyond that already envisaged by the The grand strategic dreams of Mr
current management. The required Pessina and fellow travellers are not suffi-
margin uplift would come from a dramatic cient for some of the sceptics.
increase in revenues achieved by renewed Mr Bubb believes that anyone paying
investment and service levels. about £11 a share would have to take ‘an
Adopting such a strategy would not be axe to Boots’ HQ in Nottingham and the
possible if Alliance Boots stayed as a bigger stores’. Such a move would be likely
public company because its investors to provoke a huge trade union backlash.
would baulk at increases in capital expen- On the other hand, if Terra Firma or
diture that could come at the expense of KKR do expand the company, they could
dividend growth. kill off the political storm forever.
I The analysis
At the outset we need to clearly identify the key players in this transaction. This record-
breaking private equity deal was spearheaded by Stefano Pessina, an Italian billionaire with
backing from the leading US private equity firm Kohlberg Kravis Roberts (better known as
just KKR). Mr Pessina had built up from scratch his European drug wholesaling business
called Alliance Unichem. This company merged with Boots in 2006 in a move that saw Mr
Pessina becoming the deputy chairman of Alliance Boots and its largest shareholder. The
additional financial muscle needed to win over the Boots’ shareholders came from KKR, a
leading player in US private equity funds.
The target for Mr Pessina and KKR was ‘Boots the Chemists‘ which has been synony-
mous with the UK high street for as long as anyone can remember. No British high street
is complete without a Boots store. The history of Boots began in Nottingham where the
business was founded some 150 years ago by Jesse Boot. A committed Methodist, Jesse
Boot believed in making medicinal products easily available to the working classes through
the simple device of lowering prices. This philanthropic approach to business also saw sub-
stantial charitable donations and a paternalistic approach to his workforce. After the 2006
merger with Alliance Unichem, the newly named Alliance Boots plc employed some
100 000 people with around 3000 retail stores.
At the time of this article two potential players were competing to take Alliance Boots
back into private ownership. KKR were up against a rival firm called Terra Firma headed up
136
by Guy Hands, the former head of Principal Finance at Nomura International in London.
Eventually KKR offered over £11 bn for the company which secured the deal as Terra Firma
withdrew from the battle. However, the result of the bidding war was that the chairman
of Boots, Sir Nigel Rudd, was able to obtain a truly astonishing price for the shares in
Alliance Boots with the final offer for each share hitting over £11. This represented a
premium of 60 per cent compared to the share price of 690 p just a year before. So, in 8
the short-term the existing shareholders were the clear winners. They would be compen-

sated very substantially in financial terms for losing their shareholding in the company.
This Financial Times article looks at this private equity deal by analysing four key issues:
Question 1: What is meant by the term private equity?

At the time of this rush of private equity deals it was common in the newspapers to see
the leaders of private equity being presented as crazed barbarians going on a ruthless
debt-fuelled acquisition spree and looking to earn millions on the back of the workforce
who would face mass sackings. So is this a fair description of private equity?
Most corporate finance books begin by comparing companies that are private busi-
nesses with those that are public limited companies. The main difference is that in a public
limited company there is a clear separation between the managers of the business and the
wide range of shareholders who actually own the business. This means that the senior
executives of a public company must ensure at all times that they are acting in the interests
of their shareholders. After all, the shareholders are the owners of the business. In contrast,
a private company is normally owned and run by the same person or small group of
people. As a result we do not see the same conflicts of interest between the owners and
managers of a private company.
Most of the time we read about private companies wanting to become public limited
companies. The resulting stock market floatation sees the owners of the business turn
some or all of their paper wealth into real money that they can spend. In contrast, in this
article the reverse process is taking place. KKR is looking to return Alliance Boots to being
a private company.
Question 2: How are such private equity deals financed?

The short answer to this is through a combination of a small amount of equity finance and
a much larger amount of new debt finance. Make no mistake, these deals are highly lever-
aged. The equity finance came partly from Mr Pessina himself. The rest of the equity
finance is in the form of ‘bridge equity‘ with seven of the eight banks that are funding the
deal each buying a stake in the equity themselves. At a later stage they will then look to
sell these equity states onto a third party. This carries some degree of risk for the banks
involved as their equity stakes could fall in value and they might also prove difficult to sell.
However, in the Lex column of the Financial Times on the 25 April it was argued that
the banks’ involvement in this equity part of the deal is the price they pay to be part of
the syndicate of banks providing the debt capital for the new business.
The Lex article suggests that ‘the equity to be underwritten in this transaction – estimated at
about £1.5 bn – represents about £200 m for each of the participating banks . . . But the banks
must regard it as a necessary evil rather than their preferred way to make money out of a deal’.
137
Question 3: What is the motivation for this deal?

Question 4: How can the deal makers justify paying over £11 a share
for Alliance Boots plc?
The FT article hints at the justification when it says (paragraph 3) ‘An advantage of private
equity is the ability to take tough action that would be off limits for a public company,
such as extensive lay-offs that can plunge it temporarily into the red‘. This tells us much
about the reasons for private equity deals. The aim of deal makers is to identify what they
see as ‘an undervalued company‘. They then obtain the finance to mount a bid to buy the
business outright from the existing shareholders. When the business is back in private
hands, the new managers will set about raising the profitability of the company. This will
normally involve substantial rationalisations with big cuts in costs (especially staff
numbers) and some major re-focusing of the business. Then when the time is right, they
will look to return the business as a public company, hopefully at a much higher market
value. They can then repay their debt and make a substantial amount of profit in the
process.
However, this article highlights some of the dangers in this particular deal. First, KKR
have paid dearly for the Alliance Boots business. Most independent observers find it hard
to believe that this price they have obtained is a bargain. As a result of paying such a high
price it will be much harder to make the expected return on this particular investment.
Second, the FT article argues that it will be harder for the new owners of the business
‘to take tough action that would be off limits for a public company‘. So, as we have seen,
a private company would normally be sharpening its knife ready to reduce its cost base.
However, in this case it is argued that in the case of such a well-established and iconic busi-
ness it is not realistic for the new owners to be able to take such actions without prompting
a strong backlash from trade unions, loyal customers and even the government. As the
TUC General Secretary, Brendan Barber, is quoted as saying: ‘Many such takeovers have
hit staff and customers hard as the new owners seek to make the biggest and quickest
possible buck at the expense of the long-term.’
So what are the prospects for this deal? An analyst at Pali International is quoted as
saying that KKR would struggle to generate an internal rate of return of 20 per cent if it
paid £10.90 a share for the company. The final situation looks even less attractive as KKR
ended up paying over £11 per share to secure the deal.
The current business plan of KKR was said not to involve cost-cutting plans any more
than those currently planned by the existing management of Alliance Boots. In contrast, it
is claimed that the long-term financial returns will result from a massive capital investment
plan that would try to make Alliance Boots a dominant force on a global scale. We could
see a major expansion in Europe, Latin America and Asia. The advantage of these plans
being undertaken by a private company is that it can finance the substantial capital invest-
ment needed even at the expense of the dividend growth. If it was still a public company,
many shareholders would be reluctant to give up their dividends now in return for the
much riskier prospect of a higher share value at some time in the future. At this stage it is
hard to be clear about the long-term prospects for the business. In reality, once it is out of
the public glare it is hard to imagine that we will not see some major rationalisations of the
business to generate the cost savings necessary to justify the large price paid for the shares.
138
I Key terms
the stock market as soon as possible. Once they are removed from a quoted stock market, the
private equity firms can then set about making a series of significant changes designed to
increase their ultimate market value.
8
The term ‘private equity’ is also used to cover other areas such as venture capital where new

start-up businesses receive finance in their early stages of development. Strictly speaking,
private equity is different from venture capital as the deal size tends to be much larger and the
investment is in more established companies.
We can trace the origins of private equity to the United States in the early 1980s. Many
investment banks set up private equity divisions in the hope that they could acquire companies
cheaply and later sell them on for huge profits. The biggest names in private equity have been
spun off from these banks (for example, Permira was once part of Schroder’s) or some private
equity firms were set up by individuals from within the investment banks (for example,
Kohlberg Kravis Roberts and Terra Firma).
Leveraged buyout The term ‘leverage’ refers to the capital structure of the new company
being formed. A leveraged buyout suggests that the company will be financed largely with debt
capital. This means that it will generally have a high degree of financial risk.
Tax relief on interest The tax treatment of long-term debt finance is very different to that of
equity finance. The interest on long-term debt finance can be charged against pre-tax profits
which effectively means that the taxpayer subsidises the cost of debt finance. In contrast, divi-
dends are merely an appropriation of after-tax profits. As a result, any interest paid is an
allowable deduction from profits chargeable to tax. The existence of this tax relief on interest
payments has the effect of subsidising any highly leveraged deal.
Internal rate of return The internal rate of return (IRR) is a widely used method for companies
to decide if a new business investment is worthwhile in financial terms. The IRR of a project is
the discount rate that equates the present value of the expected future cash outlays with the
present value of the expected cash inflows. As a result the project’s net present value is zero.

1. Why might Alliance Boots be worth much more in financial terms to a private equity
buyer than its previous stock market value?
2. What are the attractions to an investor who decides to invest part of their portfolio in
a private equity fund?
3. What are the key financial conditions that are necessary to create a buoyant market in
private equity deals?
4. What are the financial risks that face the banks that provided a significant share of the
equity finance needed to fund this private equity deal?
5. It is clear that the existing Alliance Boots shareholders are big winners in this transac-
tion. In addition, in the longer term Mr Pessina and KKR hope to make a significant
139
financial return on their investment. What stakeholders might be the biggest losers in
this private equity deal?
I Go to the web
Go to the official website of leading US buy-out fund Kohlberg Kravis Roberts. You will find
this at: www.kkr.com.
Go to the KKR investments section.
a. Take a look at a range of new investments made by KKR.
b. Produce a quick overview of the type of companies that they like to get involved with.
c. What are the key characteristics of these companies?
I Research
private equity.
Edition. The ‘buyout binge ‘ is explained on p. 560.
Hall. You should look at Chapter 20, pp. 597–603. This includes a nice section called ‘criticisms
of private equity’.
FT Prentice Hall. You should look at Chapter 11 especially pp. 343–5 for a brief introduction to
management buyouts.
140
Economic slowdown provokes unease at

private equity firm
The first article in this section focused on the private equity business nearly at its peak with
8
a rush of new deals coming almost on a daily basis and senior employees becoming mil-

lionaires in the process. Sadly for them, all good things must come to an end and this time
the crash arrived in the wake of the credit crisis. In the second article we see the adverse
impact that the declining liquidity in the credit markets was having on 3i, the biggest
European private equity firm. With its share price going into freefall, their chief executive
was edged out and a new boss faced the challenge of restoring the faith of 3i’s anxious
shareholders.
3i chief Yea quits following steep fall in

shares
Martin Arnold
Philip Yea, chief executive of 3i, parted The 54-year-old overhauled 3i’s
ways with Europe’s biggest listed private strategy, focusing on bigger mid-market
equity group yesterday after its shares fell buy-outs and growth capital deals, closing
by almost three-quarters in a year. its early-stage venture capital activity,
The surprise move came as the only launching infrastructure and listed
private equity group in the UK’s FTSE private equity arms and expanding in Asia
100 said it had written down the value of and the US.
its 50 biggest investments by 21 per cent, However, 3i shares have fallen sharply,
or £864 m ($1.2 bn), as a result of the along with most listed private equity
financial and economic downturn. groups, and are now worth less than half
The group said the departure of Mr Yea, what they were when he took over. The
who will be replaced by 3i veteran Michael shares fell 3½ p to 251¼ p yesterday,
Queen, had been a ‘mutually agreed below the 272 p at which 3i listed in 1994.
decision taken after proper discussion’. Mr Queen is a 20-year veteran of the
Mr Yea is expected to receive a severance group and most recently set up and ran its
package worth about £1 m, in line with infrastructure activity. He will face
his salary. serious challenges to turn round 3i’s
Investors and analysts told the Financial share price.
Times that Mr Yea had come under pressure The 47-year-old, who has also been
over worries about 3i’s debt levels, which finance director and head of growth
have driven the share price to record lows. capital for 3i, told the Financial Times: ‘I
Mr Yea, a former finance director at have worked very closely with Phil and
Diageo, the drinks group, joined 3i in 2004 am absolutely aligned with him on the
after a spell at Investcorp, the Bahrain- long-term strategic direction of the busi-
based private equity company. ness’.
141
Article 25 3i chief Yea quits following steep fall in shares
‘Clearly, it is a tough economic climate Even though 3i’s mid-market buy-out

out there but we’ve been through that and growth capital focus means it typi-
before and we have a strong business.’ cally uses less debt than its ‘mega
Analysts worry about 3i’s £500 m of buy-out’ rivals, investors also worry that
debt and £1 bn of capital calls that could it could be hurt by ‘leverage on leverage’.
fall due in the next three years, against The group said yesterday that it had
£620 m of cash on its balance sheet in £2.1 bn of net debt and £839 m of cash
September. deposits and undrawn banking facilities.
I The analysis
In the analysis of the previous article we gained a clear insight into the workings of a private
equity firm in the good times when profits are high and the rewards to the executives
involved considerable. The second article is designed to provide some balance by looking
at what happens when economic conditions deteriorate. The focus is on 3i, the only FTSE
100-listed private equity group based in the UK. The hard facts are that the value of its
investment portfolio had fallen dramatically, resulting in a sharp decline in share price. As
a result, the chief executive, Philip Yea, was leaving to be replaced by another ‘3i veteran
Michael Queen‘. The personal blow to Mr Yea would be offset by an exit financial package
worth some £1 m, made up of salary and additional pension contributions. This was some-
what controversial as he had been in charge of 3i during the last year when 70 per cent
had been wiped off its share price, thus seriously eroding the company’s shareholder value.
1. What was the history of 3i? 3i had been formed back in 1945, as the Industrial and
Commercial Finance Corporation, by the Bank of England and all the leading UK
banks. It was designed to provide long-term investment cash aimed at smaller and
medium-sized enterprises. The business was floated on the London Stock Market in
1994 at an initial share price of 272 p valuing the whole business at £1.5 bn.
2. What were the main problems facing 3i in early 2009?
a. Financial risk: the article points to the severe worries about 3i’s rising debt levels
with the company reported to have a net debt of £2.1 bn. This gave rise to the
possibility that 3i, like any other highly geared company, could even go bust if the
current adverse market conditions persisted for several years and future refinancing
was not forthcoming.
b. Business risk: in the prevailing economic climate of that time private equity firms
would always be likely to face a severe drop in returns with the credit crisis causing
large write-downs in the value of their portfolio of investments. They might have
had a share in a business valued at some £100 m a year or so ago. That same busi-
ness could now be worth much less, resulting in a severe loss to the private equity
firm. In addition the lack of available bank finance was making it much harder for
private equity firms to borrow the money they needed to fund future deals. These
were hardly the ideal conditions for a private equity firm to prosper.
142
c. Regulatory risk: as if the economic background was not bad enough, these firms
also faced a future where they were becoming much more heavily regulated by
governments around the world. The heady days of self-regulation were fading fast.
3. How was 3i positioned against this background? The short answer was while 3i was
struggling, it was nevertheless in a somewhat better state than certain of its rivals who
had much higher levels of debt to service. In addition, in recent years the strategy of 8
the business had been refocused towards the sorts of deals that might be viewed as

being more defensive:
a. Mid-market buyouts: it is generally thought that it is safer to back new businesses
where the existing managers are buying the business from its current owners. This
is because they should have much better knowledge of the business looking from
the perspective of an insider.
b. Growth capital deals: by focusing on these sorts of companies, 3i was clearly
looking for business opportunities that offered the prospect of above average
growth in future years.
c. Early-stage venture capital deals: these would be the more risky types of proposi-
tions as a significant number of these types of businesses would, sadly, fail to
survive. In the market conditions prevailing in early 2009 these would be very hard
to finance.
d. Infrastructure deals: in these deals 3i would be taking a stake in new projects that
were focusing on investments in schemes ranging from transport systems to new
sports stadiums. In reaction to the economic downturn governments across the
globe were keen to initiate such projects in order to provide vital new employment
opportunities.
4. What was the future like for 3i and other private equity firms? In the immediate
future all private equity firms had to face up to the fact that debt, the lifeblood of the
industry, was virtually unobtainable. As a result, private equity firms that make use of
a mix of investor funds and bank finance to buy companies had to alter their business
plans. This was mainly by changing to deals that were much less reliant on debt
finance or where no borrowing was required. Indeed there had even been some
private equity deals done on an ‘all-equity‘ basis. For example, in November 2008 the
Financial Times reported one such deal with BC Partners €500 m+ buy-out of SGB
Starkstrom Gerätebau, the German transformers maker which was done with debt. The
attraction of such deals was that they were considered to be far less risky than tra-
ditional deals.
I Key terms
Private equity groups Put simply this is a group of companies that raise finance from investors
and then use this cash to buy a company which they will then remove from the stock market.
This means they are holding unlisted, privately owned shares. A more complete definition is
given in the ‘key terms’ section for the previous article.
143
FTSE 100 We start with the FTSE 100 which is the most widely quoted UK stock market index.
It is based on the value of the 100 largest UK companies in terms of their market capitalisation.
It started with a base level of 1000 in January 1984. This index is now quoted in real time on
the various news information systems that serve the City traders.
Severance package This refers to the pay and benefits that an employee receives when their
employment contract is terminated. It will normally be partly additional salary as well as some
contribution to their pension fund.
Market buyouts This term is normally associated with the provision of finance to help the
existing managers of a business take control of their company. The private equity firm will help
them fund the buyout in the hope of generating a significant return for their shareholders.
Growth capital deals This refers to the provision of finance to those companies that seem to
offer the prospect of particularly high rates of growth. This might be because of the type of
service or goods that they provide. For example, a high-technology company might be viewed
as being higher growth than a utility like an electricity supplier.
Venture capital activity This is the form of finance that is normally provided to young start-up
companies. The idea is to help them survive and then expand in their early years of trading. In
return, the hope will be that they might provide an exceptionally high rate of return for the
venture capital company. This is a classic form of high-risk but high-return investment.
Infrastructure This is defined as investment projects that will focus on a nation’s basic network
of assets such as roads, railways, communications systems, etc.
Capital calls This can be defined as any additional money that equity holders will be required
to provide to meet a financial deficit. In this case the worry is that 3i has £0.5 bn of debt plus
an additional £1 bn of additional capital required in the next three years.

1. Why are the fortunes of private equity companies so sensitive to the general economic
outlook?
2. What actions does a private equity firm take once it gains the ownership of a business?
3. Explain how a combination of financial and business risk has impacted adversely on the
performance of 3i.
4. At this time 3i was generally regarded as representing the cautious face of private
equity compared to the even more aggressive end of the private equity spectrum.
What evidence can you find to support this view?
5. The article points out that 3i’s share price has fallen sharply to hit a low of just over
251 p, which was below their initial price when they listed in 1994. Which factors
might explain this sharp fall in their share price?
144
I Go to the web
Go to the official website of 3i, Europe’s biggest listed private equity group at:
www.3i.com.
Go to the section marked Investment Approach. Take a look at each section:
a. buyouts 8
b. growth capital

c. infrastructure
d. quoted private equity
e. smaller minority investments
f. venture capital.
Now prepare one PowerPoint slide on each of the above private equity investment strat-
egies being used by 3i. You should explain clearly how 3i uses this form of investment to
generate value for their shareholders.
I Research
private equity.
Fraser-Sampson, G. (2007) Private Equity as an Asset Class, Chichester, UK: Wiley Finance Series.
Hall. You should look at Chapter 20, pp. 597–603.
Prentice Hall Financial Times. You should look at Chapter 11. See the section on divestments on
p. 341.
Wright, M. and Brining, H. (eds) (2008) Private Equity and Management Buy-outs, Cheltenham,
UK: Edward Elgar Publishing Ltd.

145
Topic 9
Dividend policy
There is always a great deal of pressure on companies to provide adequate rewards to
their shareholders. This topic can be seen as part of the increased emphasis on ‘value-
based management’. This is essentially a managerial approach to corporate strategy that
puts the primary focus on maximising shareholder wealth. In response to this trend, you
will increasingly see a company’s annual report and accounts making some explicit
reference to the goal of maximising shareholder wealth.
A key aspect of most companies’ attempts to maximise the wealth of their shareholders
is the regular payment of income to them in the form of dividends. This subject plays a
vital role in nearly all aspects of corporate finance. To illustrate, here are just three
examples:
1. When we look to place a value on a particular company’s share, the level of divi-
dends it pays will lie at the heart of most of the financial models that are used.
Indeed the most important of these is actually called the dividend valuation model.
2. In a similar way, whenever the topic of share price efficiency is discussed, the
company’s dividend policy has a significant impact on its share price. So, if a
company is able to announce a sustainable increase in its annual dividends you can
expect a sharp rise in its share price wherever an efficient market exists.
3. Finally, in the area of mergers and acquisitions it is common for companies that are
being targeted by an aggressive corporate raider to seek to secure the loyalty of their
existing shareholders by promising higher dividends either now or in the future.
It is clear from the above discussion that, if we want to learn about corporate finance,
we need to understand the dividend policy of companies. We should start with the
basics. The amount of annual dividends to be paid to shareholders is set by the
company’s board of directors and is subject to the approval of the shareholders. Most
UK companies will split the annual dividend into an interim and a final payment paid six
months apart. It is important to understand that not all companies will pay dividends.
Any loss-making businesses will be unable to pay them and other fast-growing ones will
choose to re-invest all available profits rather than make cash payments to their
shareholders. This is quite sensible as long as the company senior managers are
convinced that they can secure a better financial return on these investments than the
shareholders could obtain if they were investing the cash themselves.
Sometimes instead of paying a cash dividend a company can opt to reward shareholders
with additional shares. This is called a ‘stock’ or ‘scrip dividend’. For example, a
company might announce a 5 per cent stock dividend, which means that each
shareholder gets an extra five shares for every 100 they own.
Dividend policy
If a company want to return a particularly large amount of cash to its shareholders it can
announce a special dividend payment. The intention is that, in labelling it ‘special
dividend’, the shareholders will not expect it to be maintained in the future. For
example, in March 2007 the Drax Group, the UK’s largest coal-fired electricity generator,
paid a special dividend after pre-tax profit more than doubled due to high power prices.
The company announced that it would give 32.9 p a share, or £121 m, to shareholders
as a special dividend as well as a final of 9.1 p a share.
Before we get into the particular articles chosen for this section of the book there are
two further aspects of the company’s dividend policy that can be important in practice.
They are:
1. The clientele effect. If you ask someone why they own shares in a particular
company, their answer can sometimes be highly revealing. Sometimes they will say
that they like these shares because they pay a good level of dividends on a regular
basis; while others might say they like certain shares because they have delivered a
strong growth in the capital value over many years. This is the clientele effect in
practice.
Put simply, it says that there is a natural clientele for those shares that pay out a
high proportion of earnings and another quite different one for those shares that
have a low pay-out rate. This puts pressure on the management of all companies to
produce a stable and consistent dividend policy that is in line with their shareholders’
expectations. If they move away from this usual flow of dividends, this inconsistency
will result in a fall in popularity with their normal client group.
A classic example of a clientele shareholders group that is often highly reliant on
dividend incomes is older retired people who use their shareholdings to bolster their
pensions. As an example, when the UK government planned to purchase preference
shares in a number of UK banks in the autumn of 2008, they ruled that the banks
would be prevented from paying any ordinary dividends out until the government
had their money repaid in full. This resulted in a number of complaints from pen-
sioners, who stated that the loss of this income would have a very negative impact
on their standard of living at a time of rising prices.
It is sometimes argued that with an efficient capital market companies should not
worry too much about maintaining a consistent dividend policy at all times. The
claim is that shareholders can do just as well with holdings in companies where the
focus is on share price growth rather than funding dividends. Shareholders in these
companies can sell some shares each year, effectively making their own ‘home-made
dividends’. In reality, this process might be rather costly and inconvenient as many
people will not want to be forced to sell small parcels of shares each year. They
prefer their dividends which are more predictable.
2. The information contained in dividend decisions. Now we should move on to
consider the kind of message that a company’s dividend policy can signal to
investors. There is little doubt that the annual dividend announcement is normally
seen as an important signal of the future performance of the company. The senior
managers who set the level of dividends are operating from inside the business,
148
Dividend policy
which gives them greater information about the company’s current trading. This
means that the decision to increase dividends can be taken as a good signal as the
senior managers perceive future earnings to be strong enough to sustain this trend.
If you read the Companies and Markets section of the Financial Times on a regular
basis, you will certainly see that the announcement of dividends is seen as a vital
process. A cut or missed dividend is viewed as a big event which results in a sharp 9
fall in the company’s share price.
DIVIDEND POLICY
I have selected two articles to highlight the key issues in the area of dividend policy. In
the first we see what happens when companies actually have more cash than they need.
In these cases they seek to return surplus funds to their shareholders. The article looks at
the relative attraction of using share buybacks compared to the more common method
of simply paying out cash dividends to shareholders. In the second article we look at a
company, De La Rue, which is in an enviable position of having spare cash that it
decides to distribute to its shareholders in the form of a special dividend.
Article 26
Shareholders taking a stand on handouts
Financial Times, 19–20 May 2007
Article 27
De La Rue pays special dividend

I dividends;
I special dividends;
I market capitalisation;
I capital expenditure;
I redeemable ‘B’ shares.
149
Have share buybacks gone too far?

Many corporate finance activities involve companies raising additional finance to enable
them to invest in new capital projects. However, sometimes we see the reverse when
companies actually have more cash than they need. In these cases they look to return
surplus funds to their shareholders. The first article looks at the relative attraction of using
share buybacks compared to the more common method of simply paying out cash divi-
dends to shareholders. It suggests there is some evidence that companies which offer
share buybacks might actually see their share prices underperform compared to those
companies which instead used surplus cash to support the steady growth of dividends.
Article 26 Financial Times, 19–20 May 2007 FT
Shareholders taking a stand on handouts

Chris Hughes
Investors used to be grateful when Background

companies promised to return buckets full
Companies have enjoyed a strong recovery
of cash. These days they seem to shrug their
in profitability in recent years, creating
shoulders at corporate handouts. Many are surplus capital that they have distributed
even rebelling against the most common to shareholders. Many companies have
method of cash-return – the share buy-back. chosen to do this via share buy-backs –
Last year was a record year for cash repurchasing their shares in the stock
returns to investors, with UK companies market and cancelling them, thereby
funnelling £108 bn their way, according to increasing earnings per share for
Morgan Stanley. That includes £46 bn of remaining investors. Last year was a
share buy-backs, up from about £28 bn in record for cash distributions by UK
2005. companies. However, companies are
But fashions are changing and share coming under increasing pressure to
buy-backs by UK companies are expected spend cash in other ways, such as by
to be only £23 bn this year, although BT raising dividends or through capital
this week said it planned to spend £2.5 bn expenditure.
Research from Morgan Stanley this
repurchasing its own stock.
month found that companies that pursued
Buy-backs took off because they were a
share buy-backs saw their shares
simple and flexible means of distributing
underperform those that consistently
cash generated by rising corporate prof- raised dividends.
itability.
They work like this. A company
instructs its broker to purchase its shares But buy-backs are not necessarily a
in the stock market. These shares are good thing. They absorb cash that could
then cancelled, which means the be spent on higher annual dividend pay-
company’s future profits are spread ments or capital expenditure.
among fewer shares, so each remaining If a company’s stock is overvalued, the
share becomes more valuable. company wastes money buying it – just
150
Article 26 Shareholders taking a stand on handouts
Top 20 companies by buy-back yield growing dividends have performed better

Buy-backs Buy-back
over the past decade than those pursuing
(£m) yield* buy-backs, according to Morgan Stanley.
Psion 84 83.0 Private shareholders have long
First choice 200 26.1 opposed buy-backs because they think
Computacenter 75 15.5 they cannot participate in them. This is a 9
Wetherspoon (JD) 79 13.9 fallacy given that anyone can sell shares
DIVIDEND POLICY
Evolution 50 13.2
in the market during a buy-back and the
Biocompatibles 12 12.6
Enterprise Inns 388 12.6
price at which buy-backs are conducted is
Pennon 138 12.0 regulated.
SurfControl 15 11.1 At Royal Dutch Shell’s annual meeting
Rank 201 10.5 this week, a disgruntled shareholder drew
Hays 209 10.2 applause when he thanked the oil
Burberry 192 9.8
company for stopping its share buy-back,
Capita 245 9.0
citing Morgan Stanley’s research.
Spirent Comms 42 8.6
Reuters 527 8.5 ‘You’ve returned £16.3 bn in dividends
InterCont Hotels 307 8.4 and buy-backs. Thank you for my divi-
Next 341 8.2 dends, I have banked them’, he said. ‘Tell
Vodafone 6457 7.2 me, how do I bank my buy-backs? . . .
Anglo American 2111 7.1 Where is [the money] exactly?’
BP 8155 6.7
There was a similar incident at the
* Buyback to average market cap 2005 and
2006 results
Unilever annual meeting the following day.
Source: Morgan Stanley Institutional investors are also taking a
stand. Stuart Fowler, fund manager at
like any other investor. And to the extent Axa Investment Managers, says: ‘We
that stock repurchases are good for the prefer dividends to buy-backs and we
company’s continuing investors, they are state that very plainly to companies that
correspondingly bad for those who sell out ask. You would have thought that by now
during the buy-back. more companies would have spotted what
Shares in companies that have been Morgan Stanley has found’.
UK companies’ total cash returns

By type (£bn)
Buy-backs
Dividends
70
60
50
40
30
20
10
0
1993 96 98 2000 02 04 06* 07*
*Estimates
Source: Morgan Stanley
151
He says that companies such as BPB, Ted Tuppen, chief executive of

BAA, BOC might still be independent if Enterprise Inns, says investors seem to
they had paid higher dividends and there- prefer buy-backs because they do not
fore commanded higher share prices – a trigger a taxable event like a dividend.
lesson for Rio Tinto, which is currently ‘When we asked our shareholders, the
the subject of takeover speculation. overwhelming response was that they pre-
‘Rio is the sort of company where ferred share buy-backs. But fashions
putting the dividend up would help defend change, and you get to a point when it’s
its borders’, he says. not earnings enhancing.’
Euan Stirling, investment director, UK Mr Tuppen says companies are not
equities at Standard Life, says: ‘There can being cajoled into buy-backs by bankers,
be value creation from buying back cheap since it is possible to negotiate very low
shares. But if companies have a perma- commission rates with brokers.
nent increase in their cashflows, dividends Jim Clarke, finance director of JD
are the best way to distribute this to share- Wetherspoon, says: ‘Most of our long-term
holders. There is plenty of scope for UK large shareholders have said they see buy-
companies to grow dividends from here’. backs creating more value than putting
Other investors want cash to be spent on up dividends’.
capital expenditure instead. Robert Waugh, He says the company buys its shares
head of UK equities at Scottish Widows when their free cash-flow yield exceeds its
Investment Partnership, says: ‘Buy-backs cost of borrowing.
can make sense at the right price, but we Ian Burke, chief executive of Rank,
prefer good management to invest more in says: ‘There are a lot of factors that influ-
the business. At the moment most invest- ence the decision about how you return
ment is going on expensive acquisitions’. capital. We have used both buy-backs and
Neil Darke, analyst at Collins Stewart, a special dividend’.
has campaigned against ill-judged share So should companies continue buy-
buy-backs, arguing that investment banks backs? It depends. Collins Stewart
advise companies to do buy-backs because research has found that buy-backs trigger
their equity desks make easy commission share price outperformance when the
from them. He says other means of capital company also has a low valuation, a repu-
return – such as special dividends or tation for disciplined capital investment
redeemable ‘B’ shares – are preferable, and a strong balance sheet. ‘A buy-back is
since they do not differentiate between only a catalyst for correcting undervalua-
selling and buying shareholders. tion – it is not a value creator in itself’,
But management at companies that says Mr Darke.
have been buying back shares are quick to
dismiss criticism.
I The analysis
According to the US investment bank Morgan Stanley, 2006 was a record year for
companies returning surplus cash to shareholders. The total figure of some £108 bn
included share buybacks of £46 bn. This method is often favoured because it is cheap and
easy to organise. A company just needs to instruct a broker to go into the market and
start buying its own shares. These shares are then cancelled, which means that each
remaining share is now worth more in line with the higher level of earnings per share.
152
This process benefits all shareholders through the rise in the capital value of their share
holdings.
However, there are some problems with this method of returning value to shareholders.
First, when a company decides to use spare cash to purchase its own shares, it is inevitably
at the expense of paying higher dividends which is a more visible form of monetary return
to shareholders. It is possible that some private shareholders do not fully understand the 9
share buyback process. This might be the reason that some shareholders at recent
DIVIDEND POLICY
company annual general meetings have been questioning the value of share buybacks.
They argue that while they could bank their dividends they could not bank their share buy-
backs. Even some leading institutional investors express a preference for dividends. Stuart
Fowler at Axa Investment Management says ‘we prefer dividends to buybacks and we state
that very plainly to companies that ask’.
A second argument against share buybacks comes from the research at Morgan Stanley
which suggests that companies that have been concentrating on growing their dividends
have seen a better performance compared to companies that made share re-purchases.
The argument seems to be that if a company has been able to produce a permanent
increase in its cash flow, the correct response is to signal this greater confidence in their
future prospects by raising dividends.
Finally, there is the argument made by Robert Waugh, head of equities at Scottish
Widows Investment Partnership, who would like to see companies spend any spare cash
on additional investment projects. In some ways a share buyback programme is a nega-
tive outcome. The company is saying that it cannot identify any suitable investment
projects so it is handing the cash back to shareholders to make their own investments.
If companies cannot readily identify any suitable investment projects, Neil Darke an
investment analyst at Collins Stewart would like to see them make special dividends or to
issue class B redeemable shares. The attraction is that these are highly visible and they are
paid to all shareholders. The same firm identifies the perfect candidate for a successful
share buyback, they must have ‘a low valuation, a reputation for disciplined capital invest-
ment and a strong balance sheet’. In this situation the share buyback can be seen as the
starting point for a revaluation of the company.
I Key terms
Share buybacks This is an increasingly common method for companies to return cash to their
shareholders. The process is relatively simple. The normal technique is for companies to make
a ‘tender offer’ to all shareholders inviting them to sell their shares back to the company at a
set price. Second, a company might offer to buy from a particular group of shareholders.
Finally, the company could make a stock market purchase of its shares. In this last case there
will not be one set price, as this will vary depending on the exact timing of the share re-
purchase. In all cases the company will cancel the re-purchased shares so that the earnings per
share will increase, assuming that earnings remain the same and that there are now a reduced
number of shares in existence. It should be noted that a share buyback is a voluntary arrange-
ment for the shareholders. They can always decline the offer from the company and keep their
shares.
153
Capital expenditure This is where a company spends money on various types of fixed assets
such as property and plant and equipment. These assets cannot easily be turned into cash and
are generally viewed as long-term investments.
Redeemable ‘B’ shares This refers to a type of share capital which has reduced or zero voting
rights. These shares are generally redeemable which means that they have a fixed life unlike
most ordinary shares which have an infinite life. In recent years a number of companies have
given their shareholders redeemable ‘B’ shares instead of cash dividends.

1. From the point of view of shareholders what are the main differences between a
company returning any surplus cash to them in the form of:
a. Redeemable ‘B’ shares?
b. A special dividend?
c. A share buyback?
2. What are the main reasons that private shareholders and institutional shareholders
might have different attitudes to the possibility of a company making a share re-
purchase instead of simply raising normal dividends?
3. Why is it argued in this article that paying higher dividends might protect a company
from a possible takeover bid?
I Research
Arnold G. (2007) Essentials of Corporate Financial Management, Harlow, UK: FT Prentice Hall. You
should look at pp. 433–5 to see more information about share buybacks.
should especially look at Chapter 22, p. 853 to get more information about share buybacks.
You should look at Chapter 9, especially pp. 386–7.
The payout policy for companies is set out in Chapter 17.
Edition. The dividend policy of companies is covered in Chapter 13.
Financial Times. The dividend decision is covered in Chapter 12.
Hall. You should look at Chapter 17, pp. 474–7 to see a very clear discussion of share buybacks.
154
Printing money pays big dividends for De

La Rue
This article looks at De La Rue plc, the company that makes its money by printing bank-
notes all around the world. This company went through some tough times back in early
9
2003. The company issued three profit warnings in just over seven months. As a result the
DIVIDEND POLICY
share price fell sharply to just over 190 p. However, times have changed and this company
is now viewed as a very successful business. The company is at the forefront of new tech-
nology and as a result earnings are very strong and the company is cash rich. It is therefore
looking to return some of this money to shareholders through a special one-off dividend.
Against this background the share price hit nearly 750 p.
De La Rue pays special dividend

Tom Griggs
De La Rue, the banknote printer, is to pay a contributions will increase by 1 per cent
special dividend to shareholders as it by June 2008 and future increases in life
pointed to a strong backlog of orders at both expectancy will be borne by members by
its currency and cash systems businesses. an adjustment to the pension accrual rate.
Leo Quinn, chief executive, said new De La Rue has also agreed to pay off the
security features and innovative cash- current £57 m deficit over the next six years.
counting machines had driven a 12.6 per Two years ago it shifted two factories to
cent rise in revenues to £687.5 m and a 34 China to cut costs. Mr Quinn said there
per cent rise in pre-tax profits to £102.4 m. was ‘still a significant way to go’ with cost
He added that the group had generated savings.
cash flow of £144 m in the year to March Earnings per share rose to 43.9 p
31, representing 140 per cent of operating (31.4 p).
cash flow. The shares added 1 p to close at 726 p.
De La Rue raised its dividend 12.4 per
cent to 19.1 p with a 13.27 p final and FT comment: After a positive trading
announced plans for a special distribution update, investors had expected Mr Quinn
of 46.5 p, worth about £75 m. to announce the cash return. But the
Mr Quinn said the group will have prospect of another good year will add a
returned £283 m to shareholders over the further support to the shares. De La Rue
past three years, representing 50 per cent trades on a price/earnings multiple of
of its market capitalisation from three about 16.8 times 2008 estimated earnings
years ago and double free cash flow over – which seems about right for the time
the period. being. The company is operating near to
Stephen King, finance director, added full capacity and future cost savings will
that De La Rue had completed its pension be harder to find. After such a strong year,
review. The normal retirement age has these results are going to be difficult to
been increased from 62 to 65, member’s live up to next time around.
155
Article 27 De La Rue pays special dividend
I The analysis
The announcement of a special dividend can hardly have come as a big surprise to
investors as it came just after a recent very positive trading update. De La Rue, the
company that prints banknotes, has become a very successful business. It is a company
with a licence to print money that has been able to translate this into real cash for its share-
holders. The latest set of figures were very strong, with revenues up by nearly 13 per cent
to £687.5 m. There was a sharp rise in earnings per share to 43.9 p. Even more signifi-
cantly the company was full of spare cash with a positive cash flow of some £144 m in the
year to 31 March 2007.
This very positive cash position has enabled the company to raise the normal dividend
by 12.4 per cent to 19.1 p. In addition, it announced a special one-off dividend of some
46.5 p per share. The chief executive is reported as saying that the company has now
returned £283 m to shareholders in the three years. This means that if you bought some
shares in the company just three years ago, you would have now received 50 per cent of
the purchase price back in the form of cash dividends.
The Financial Times comment piece gives a favourable outlook for the company. It sug-
gests that it is trading at a price–earnings (PE) ratio of around 17 times estimated future
earnings ‘which seems right for the time being’. However, it suggests some caution ahead
as in the longer term it might prove difficult to maintain this strong performance. As usual,
the future is always more uncertain than the past.
I Key terms
Dividends A normal dividend is simply the payment made each year to all shareholders in the
company. The exact level is set by the company’s board of directors. This payment will be made
to all shareholders who are registered on a particular date. In most cases these dividends are
paid in cash.
Stock dividend A stock dividend is where the company rewards its equity investors with
additional shares rather than a cash payment.
Share buyback A share buyback is where the company uses spare cash to buy their own shares
in the stock market with the explicit aim of increasing the share price.
Special dividend Finally, a special dividend refers to the situation where a company decides to
return any surplus cash to shareholders through a one-off payment. This should be seen as an
additional payment on top of any expected normal dividend. The significance of labelling this
dividend as ‘special’ is that it is a signal from the company that it will not be able to maintain
annual dividends at this higher level. It is a one-off benefit that shareholders should not see as
becoming the norm.
Market capitalisation This gives the current overall stock market value of the company. It
can be easily calculated by multiplying the numbers of shares in issue by their current market
share price. In some cases companies will have more than one class of shares. In this case it
is necessary to add together the different classes of shares to get the total value of the
company.
156
Price–earnings ratio The PE ratio is calculated by taking the market share price and dividing it
by company’s earnings per share. This ratio is often used to compare the current stock market
value of a company.
So in this case what is the company’s price–earnings (PE) ratio?

9
This can be calculated by taking the share price (726 p) and dividing it by the
DIVIDEND POLICY
company’s earnings per a share (43.9 p). This gives us an answer of 16.5 to be precise.

1. It is often said that the dividend announcement made by a company is an important
source of information about the future prospects for the business. In this case what
signal is being given by De La Rue plc in the decision to raise the annual dividend by
12.4 per cent and in addition to announce a special one-off dividend of 46.5 p?
2. How else could the company have used this spare cash?
You will need the Companies and Markets section of the Financial Times for any Monday
edition. Go to the London Share Price Service. This is normally the two pages inside the
back page of the Companies and Markets section.
Take a look at the Bank’s Sector.
Look only at the Banks in the FTSE 100. They are all shown in bold.
1. Which bank pays the highest dividend in pence?
2. Calculate the dividend yield for this bank based on its current market share price.
3. Which bank has the highest market capitalisation? Do not forget that you need to add
all classes of shares. For example, HBOS has three different preference shares.
4. Which bank has the highest dividend cover?
5. Which bank has the lowest dividend cover?
I Research
Arnold G. (2007) Essentials of Corporate Financial Management, Harlow, UK: FT Prentice Hall. You
should look at Chapter 12.
You should look at Chapter 9.
The payout policy for companies is set out in Chapter 17.
157
Edition. The dividend policy of companies is covered in Chapter 13.
Financial Times. The dividend decision is covered in Chapter 12.
Vaitilingam R. (2006) The Financial Times Guide to Using the Financial Pages, 5th edn, Harlow, UK:
FT Prentice Hall. You should look at Chapter 5. This has an excellent explanation of the London
Share Price Service including market capitalisation, dividend cover etc.

158
Topic 10
Mergers and acquisitions
Mergers and acquisitions (M&A) play a very important role in corporate finance. For
example, they help to ensure that the managers of a business act in the best financial
interest of their shareholders by maximising the company’s share price. If the share price
starts to slide, they know that they risk another company coming in and making a
takeover bid for the business which will almost certainly see the managers lose their
well-paid jobs. M&A activity also enables companies to grow their business by being
able to exploit opportunities for external growth. This is particularly important where the
scope for internal growth is limited. For example, a particular company may be highly
successful in growing their business, but in the end it reaches a point where the size of
the total market for their product or services rules out any further expansion. In these
situations there is little choice for the company but to seek out opportunities to expand
their horizon by corporate mergers or takeovers.
At the outset it is important to set out clearly the terminology that is applied to this area
of corporate finance. In practice, the terms ‘merger’ and ‘acquisition’ or ‘takeover’ are
often used quite interchangeably. However, strictly speaking, ‘merger’ should imply a
more friendly deal with both companies fully consenting to the combining of their
assets. In contrast, when we refer to an acquisition or takeover there is a clear
suggestion that one company is chasing the other in a more aggressive manner. The
predator sees a clear financial gain to be made by securing the assets of the target
business and using them to its advantage. This distinction is clear from the following
well-used descriptions in this area:
I A friendly merger. The companies are normally of equal size and they see a mutual
interest in the deal being made.
I A hostile takeover. Normally a larger company is attempting to take over a smaller
business rival.
Having established the distinction between mergers and acquisitions or takeovers we can
now define three categories within this type of corporate activity:
1. Horizontal M&A activity. In this case we have two companies from the same indus-
trial sector both of which are involved at the identical stage of production. For
example, when easyJet took over Go in 2002, it was a case of one budget airline
taking over another.
2. Vertical M&A activity. Here we have two companies operating at quite different
stages of production that merge their activities. For example, a new TV company
might acquire a business that makes new programmes in order to ensure a run of
high-quality content in the future.
3. Conglomerate M&A activity. In this last case we see two companies from unrelated
business sectors coming together. This results in the creation of large industrial con-
glomerates like ArcelorMittal which employs over 320 000 people in over 60
countries. It has interests in steel, cars, construction, packaging and household goods.
Before we start to examine the articles included in this section we should briefly examine
the economic reasons often used to justify M&A activity. We can list the main arguments
as follows:
1. Synergy. Perhaps, the most powerful argument in favour of M&A is that it can lead
to significant gains through the exploitation of the synergies that exist between the
two companies involved. In this view the value of the combined business is going to
be significantly higher than the simple sum of the values of the two companies. This
can be because the new business will be able to make significant cost savings or
enhanced revenue opportunities thanks to its more powerful position in the market.
It is certainly the case that following virtually all M&A deals, there will soon be
announcements of rationalisations as duplicated operations are shut down. If there
are many winners from M&A deals, the losers are often the lowliest employees who
find their services quickly becoming surplus to requirements.
A great example of synergy in practice was provided by the Lloyds TSB bid for
HBOS in the autumn of 2008. When they unveiled the updated terms of their bid on
the 3 November 2008, they suggested that the combined new group would make
cost savings of some £1.5 bn per year. Inevitably these would come largely in the
form of significant job losses.
2. Immediate access to new markets. I can remember that, when the eurozone was
about to be created with the introduction of the new single currency, an economist
in an investment bank published a new research note titled ‘the urge to merge’. His
argument was that ahead of this development the easiest way into this new market
was through the acquisition of a leading European company that already had a sig-
nificant presence within this market. This shows how M&A activity can be viewed as
one way to gain access to new market opportunities.
3. The motives of ambitious managers. It is often argued that much of M&A activity
can be traced back to purely managerial motives. The directors of a business see it as
being in their best interests to search for the opportunity to grow their business fast
by the acquisition route. As a result they will find their status and remuneration on a
fast upward curve.
4. Spreading risk through diversification. A better reason for M&A activity is that a
company might be able to reduce its exposure to business risk through the expansion
into a wider range of corporate activities. For example, if there is downturn in demand
for gym memberships, this will have less impact on a range of sports clubs that also
offer tennis courts, physiotherapy, health and beauty and hotel accommodation.
5. The opportunity to buy an undervalued company. It is often the case that the
drive to launch a takeover bid might come from the perception that the target
company has been significantly undervalued by the stock market. The aim will be to
160
buy up the business and re-focus it in some way so this hidden value can be better
exploited. This is often the case when there is a general fall in share prices, which
can result in an unjustifiably steep fall in a particular company’s market value.
Whatever the reasons for M&A activity, there is something about it as a subject which
always seem to intrigue students of corporate finance. It is most likely to be the fierce
battle that often takes place as two or more rival bidders fight for the ownership of a
10
company. The embattled company usually has to fight hard to maintain its
MERGERS AND ACQUISITIONS

independence, and in these articles we compare two different forms of tactics used to
defend companies in the face of a hostile bid.
Articles 28
Discussions unlikely to yield white knight
Articles 29
Mittal goes on Arcelor charm offensive
Article 30
Poison pill’s strength under analysis

I mergers, takeovers and acquisitions (MTA);
I financing of MTA;
I defence mechanisms;
I white knights;
I poison pills;
I warrants;
I greenmailer.
161
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In this first case we look at the charismatic figure Lakshmi Mittal, the owner of Mittal
Steel, who launched a takeover bid for Luxembourg-based Arcelor in 2006. This was a
strongly contested bid with Arcelor, proud of its position as Europe’s leading steel pro-
ducer, determined to maintain its independence. Indeed at this stage there was the
possibility of the involvement of a so called ‘white knight’ in the shape of Nippon Steel.
They might have formed an alliance with Arcelor in an effort to fend off the advances
from Mittal steel.
Discussions unlikely to yield white knight

Mariko Sanchanta
When Akio Mimura, president of Nippon aim of the original arrangement with
Steel, sits down in Paris today to speak Usinor – later subsumed into Arcelor –
with Guy Dollé, head of Arcelor, they will was to provide Japanese car companies
have more to talk about than just the in Europe with similar grades of steel
state of their five-year-old technical to Japan. ‘In the late 1990s Nippon
alliance. Steel had no alternative but to tie up
The long-set meeting comes less than a with Arcelor, as they couldn’t export
week after Mittal Steel launched its their steel to Europe’, says Mr
hostile bid for Arcelor. McCulloch. ‘Now, from Nippon Steel’s
The meeting has fuelled speculation point of view, what could Arcelor
that Nippon Steel might act as ‘white provide them with?’
knight’ to help fend off Mittal’s advances. Nippon Steel has emerged from Japan’s
Mr Dollé has said he is open to discussions recession of the 1990s and is on track to
with other companies about uniting and report a record profit for the second year,
making things more difficult for Mittal. which reflects strong pricing power for its
But such an agreement might not make high-grade steel products despite a steep
sense for Nippon Steel, Asia’s leading increase in raw material costs.
steelmaker and the world’s third largest. Nippon Steel’s determination to remain
Analysts say a stronger union with independent has put it at odds with JFE,
Arcelor is likely to yield little for Nippon a Japanese rival, created in 2002 via a
Steel, which has refused to join the wave merger between NKK and Kawasaki
of industry mergers. Steel.
Russ McCulloch of Steel Business ‘Merging with a foreign steelmaker
Briefing, a trade publication, says the wouldn’t make much sense for Nippon
162
Article 29 Mittal goes on Arcelor charm offensive
Steel or JFE, because it wouldn’t give had no plan to make a play for the
them more clout over their biggest cus- European steelmaker. ‘We do not have
tomer – the Japanese carmakers’, says one any plans or any intentions over
Japanese steel analyst. ‘It would make Arcelor’, Han Dong-hee, a spokesman,
more sense to consolidate domestically. says.
The only merit a merger with a foreign Tata Steel, India’s largest private- 10
company would bring the Japanese makers sector steel producer, has close relations

is more sway over raw materials suppliers.’ with Arcelor and Nippon Steel. The
Analysts added that it would be even Japanese company constructed a cold
less likely that JFE would align itself with rolling mill in India for Tata Steel, which
Arcelor, since it already had a tie-up with also has a technology-sharing arrange-
Thyssen-Krupp. ment with Arcelor.
Moreover, in 2001 Kawasaki Steel and However, Tata Steel is probably too
Usinor negotiated for seven months over small to make much difference in a poten-
the supply of automotive steel sheet in tial alliance of steelmakers positioned
Europe. The talks fell through and Usinor against Mittal. The company’s output is
aligned itself with Nippon Steel. about 7 m tonnes a year, although it has
According to Mr McCulloch: ‘Japanese plans to raise production.
steel companies usually don’t have short
memories’.
Other large Asian steel companies seem
unlikely to take a hand in the battle.
South Korea’s Posco said it was not Note: additional reporting by Khozem Merchant and
concerned about becoming a target, and Anna Fifield.
Mittal goes on Arcelor charm offensive

Peggy Hollinger
Lakshmi Mittal, the Indian billionaire, two companies together for the benefit of
yesterday launched a charm offensive in all stakeholders, including governments. I
France in an attempt to avert growing am sure we will convince them’.
political opposition to his €18.6 bn (£12.7 Mr Mittal’s comments followed a tense
bn) bid for Arcelor, Europe’s largest steel meeting with Thierry Breton, France’s
producer. finance minister, who is openly hostile to
Insisting there would be no job cuts or the unsolicited nature of the bid for
factory closures should his Mittal Steel Arcelor, which employs about 23 000
group succeed in its hostile offer, Mr people in France.
Mittal said he was determined to avoid Mr Mittal said there had been a ‘free
conflict with the government. exchange of views’ at the meeting where he
He said: ‘I have never confronted a gov- had explained his reasons for going hostile.
ernment in my life. We believe there is Mr Breton reiterated his ‘profound con-
strong industrial logic to putting these cerns’, saying the lack of discussion with
163
Arcelor had increased the risks that any Arcelor, formed from Franco-Spanish
merger would fail. and Belgo-Luxembourg interests, had to
He said: ‘In the 21st century, if you be protected from predators ‘even if it
want such a transaction to be successful, couldn’t be protected legally’.
you need to start with preliminary dis- Yesterday, Pedro Solbes, Spain’s
cussions between the companies involved, economy minister, said he wanted more
on a friendly basis’. information on what the bid meant for
Dominique de Villepin, French prime Spanish workers. Mr Mittal is expected to
minister, is understood to have banned meet Jean-Claude Juncker, the Luxem-
members of his government apart from bourg premier, today.
Mr Breton from speaking out, but wider Meanwhile, Guy Dollé, Arcelor chief
political opposition appeared to be gath- executive, insisted there was no industrial
ering steam yesterday. logic in putting the two businesses
The Socialist Party, with perhaps one together and railed against Mittal Steel’s
eye on the presidential election in 2007, unwelcome approach.
attacked the government for a ‘truly weak Referring to a private dinner at Mr
response’. Mittal’s home on January 13, he said: ‘It
Bernard Carayon, from the ruling UMP was made in four minutes just after the
party, said the bid marked the ‘hour of aperitifs. I think a deal of this size merits
truth for Europe’. more than four minutes after the aperitif’.
I The analysis
The first article sets out the strategy of the Mittal Steel group, headed by the Indian bil-
lionaire Lakshmi Mittal, who launched a bid of €18.6 bn for the Luxembourg-based steel
maker Arcelor on the 26 January 2006. He argued that the deal made sound commercial
sense and it would benefit all the stakeholders of Arcelor including various European gov-
ernments. This approach was designed to reassure the French government, which was
particularly hostile to the proposed bid. One serious concern was that any takeover would
result in severe plant closures and job cuts in a country where about 25 per cent of
Arcelor’s employees were located. As the Financial Times says, there was a particularly
hostile reaction from France’s Finance Minister, Thierry Breton. With an election coming
up in the spring of 2007 perhaps this was not that surprising.
The chief executive of Arcelor, Guy Dollé, is quoted as saying that he saw no industrial
logic in putting the two businesses together. Indeed, he commented on the tactic
employed by Mr Mittal in trying to explain the logic behind the deal over aperitifs at a
private dinner at the latter’s house. One potential escape route for Arcelor was the possi-
bility of persuading a friendly company to combine with them in an effort to fend off the
bid from Mittal Steel. The first article identifies Nippon Steel as a possible ‘white knight’.
However, industrial analysts are quoted as saying that such a merger would make little
commercial sense for Nippon Steel. They saw far more merit in the Japanese-based
company forming an alliance at home.
In early April 2006 Arcelor used more common tactics to fight off the takeover bid. They
announced that they would increase the 2005 dividend and distribute a further £3.4 bn
to shareholders. In addition they announced that they would transfer the shares that they
164
owned in a Canadian firm (Dofasco) to a foundation which would make it much harder
for Mittal Steel to sell this business if it succeeded in buying Arcelor.
In the end the European regulators which had investigated the proposed takeover gave
the go-ahead in June 2006. As a result Mittal Steel was able to take over Arcelor although
they ended up paying a significantly higher price. This created the world’s largest steel-
maker. The process of integrating the companies proved to be fairly trouble free. A new 10
board of directors was created with three executives from each company. The vice-

president of Arcelor, Roland Junck, became the head of the new firm. Aditya Mittal, son of
the Mittal Steel chairman, became the firm’s chief financial officer. It was perhaps signifi-
cant that the chief executive of Arcelor, Guy Dollé, had no executive role in the new
business.
The combined company’s share price performed very strongly. A Financial Times article
in spring of 2007 reported that it had outperformed the global index of all share prices by
nearly 28 per cent. The article concludes with a cautious statement from a banker close to
the business. He says that the takeover was still in the honeymoon period and considers
that ‘. . . the real tests will come later in the year when quite possibly the steel market will
start to soften and conditions for the company begin to look rather tougher’.
I Key terms
Mergers This is where two companies decide that it would be to their joint benefit to come
together to form a new business entity. With a merger the process is normally friendly with the
full consent of both sets of shareholders.
Takeover This is the purchase of one company’s ordinary shares by another company. In this
process one company is seen to dominate the other.
Stakeholders This refers to the various parties who have a share or an interest in a company.
This will include the shareholders, managers, employees, suppliers, government and the
members of the local community.
White knight This is where the company being chased will seek out an alternative friendlier
suitor that will form an alliance to act as a defence against the first bidder.

1. In early 2006 Mittal Steel launched a hostile bid for Arcelor, Europe’s largest steel pro-
ducer. Following the bid there was speculation that Nippon Steel might act as a ‘white
knight’ to help fend off Mittal’s advances. Explain what the function of a white knight
is in mergers and acquisitions.
2. Why might a bidding company be prepared to pay a premium above the market value
for the shares of a business?
3. In mergers and acquisitions what is meant by the term a ‘winner’s curse’?
165
I Go to the web
Go to the European Union’s website. You will find this at http://europa.eu/index_en.htm.
Now go to the section on Competition.
Hint: You will find this in the section: ‘What the European Union does by subject?’
Now go to the section on Mergers.
Hint: You will find this at the top of this page.
Now go to the overview section. Read this section and answer the following questions
which are set out here. Make sure you use your own words.
a. Why do mergers need to be investigated at a European Union level?
b. Which mergers are examined by the European Commission?
c. When are mergers approved or prevented?
I Research
You should look at Chapter 12. You will see a very good definition of a ‘white knight’ on p. 497.
You will find mergers and acquisitions explained in Chapter 28. You will see a definition of a
‘white knight’ on p. 890.
Edition. Mergers, LBOs, etc. are covered in Chapter 17.
Financial Times. The topic of corporate restructuring is covered in Chapter 14.
166
Can Japanese sauce spice up US hedge

fund?
Mergers and takeovers often involve fierce battles between the predator company and the
target company. These stories tend to stay in the news for weeks as rival companies get
10
involved in the bidding process and the company under attack mounts a strong campaign

to defend its independence. In this case we have a clash of cultures on several levels. First,
we have an aggressive hedge fund chasing a corporate prey. Second, we have the clash of
continents with the hedge fund based in the US and the target company being Japanese.
In addition, this Financial Times article provides an insight into the use of complex
financial market products in the area of mergers and takeovers. More specifically, it shows
us how a poison pill can be used as a defence mechanism by a company in the face of a
hostile takeover bid.
Article 30 Financial Times 15 June 2007 FT
Poison pill’s strength under analysis

Michiyo Nakamoto
Corporate litigation in Japan generally The move puts the burden on the
lacks high drama and is not something judiciary to set a precedent that some say
that arouses public excitement. will test the integrity of Japanese capi-
But the decision by Steel Partners to talism and have far-reaching consequences
file an injunction against Bull-Dog for capital markets in Japan.
Sauce’s poison pill has thrown the spot- ‘This is a very important case’, says
light on the judiciary. Nobu Yamanouchi, partner at the Day
Jones law firm in Tokyo. The way the
Major Japanese companies that have adopted
poison pills poison pill was implemented gives Steel a
Sector Company strong hand, he thinks.
Electric Matsushita, Sharp, Hosiden, Yokogawa ‘But if poison pills are not going to be
Electric effective against someone like Steel
Chemical Shinetsu Chemical, Mitsui Chemical, Fuji Partners, then there won’t be any hostile
Photo Film, Kaneka
bidder that companies will be able to use
Food Nippon Meat Packers, Meiji Dairies,
Yukijirushi, Snow Brand Milk Products, them against’, Mr Yamanouchi says.
Kagome ‘The judge is being put in a very diffi-
Steel JFE, Kobe Steel, Nisshin Steel, Maruichi cult position.’
Steel Tube
Steel Partners is seeking an injunction
Pharmaceutical Rohoto, Santen Pharmaceutical, Mochida
Pharmaceutical against a particular type of poison pill that
Non-ferrous metal Mitsubishi Material, Sumitomo Metal Bull-Dog has adopted, known commonly as
Mining, Dowa a rights issue but in Japan ominously
Paper Nippon Paper, Oji Paper, Mitsubishi Paper
dubbed SARS, for special acquisition rights.
Other Dai Nippon Printing, Kokuyo, Mitsubishi
Estate, Keio, Nippon TV
The maker of Worcester sauce and
Source: FT research other condiments is the target of an
167
Article 30 Poison pill’s strength under analysis
unsolicited tender offer by Steel Partners, that a board can kick out a shareholder’,
which has a 10 per cent stake and wants one lawyer says.
to acquire all the shares it does not own. The head of Japan mergers and acquisi-
Bull-Dog, which reacted to the tions at a leading western investment
advances with outright hostility, unveiled bank says that, if the court approves Bull-
its SARS plan, which it will put to the Dog’s measure, ‘it’s the end of the
annual shareholders’ meeting this month. Japanese capital market’.
The Bull-Dog rights issue is unprece- Japan allows poison pills under certain
dented in Japan in several respects. conditions but Bull-Dog announced the
Pending approval by shareholders, it measure only after Steel Partners made
intends to issue warrants that can be con- its bid. ‘That makes it look like the man-
verted into shares at 1 per warrant. agement is trying to protect their job’,
Shareholders, including Steel Partners, says Scott Jones, partner at Jones, Day.
will receive three warrants per share. In general, poison pills are allowed only
For Steel Partners, it is bad enough that in times of peace, when a company is not
the rights issue will dilute its share- facing a hostile bid, Mr Yamanouchi says.
holding from 10 per cent to less than 3 per Bull-Dog was not available for comment
cent. But the scheme also singles out Steel yesterday. It has said it believes its
Partners, which alone will not have the defence measure was ‘lawful and appro-
right to convert its warrants into shares priate’.
but instead will receive ¥396 per warrant. The courts have ruled against warrants
To make matters more galling, Bull- that companies have planned to issue to
Dog reserves the option of converting third parties in two cases out of three – a
Steel Partners’ warrants into cash but has poison pill by Nireco in 2005 and plans by
no obligation to do so. If Bull-Dog decides Nippon Broadcasting Systems to issue
not to exchange Steel Partners’ warrants warrants to TBS.
for cash, the fund could be left with But there is a possibility that Bull-
useless paper. Dog’s poison pill will be allowed if Steel
Steel Partners charges that the scheme Partners is deemed to be a greenmailer.
represents ‘a discriminatory act against When the court struck down Nireco’s
[it] in violation of Japanese law’, which it poison pill, it also noted that poison pills
says states that ‘a company should treat could be allowed if they were targeted
shareholders equally according to the con- against greenmailers.
tents and amounts of shares they have’. Steel Partners has had the blessing of
It says the plan is ‘only seeking . . . to Institutional Shareholder Services, which
dilute [Steel Partner’s] shareholdings and says: ‘We do not believe that Steel
stop its tender offer’. Partners’ offer is so clearly inadequate or
Many believe that if Bull-Dog’s plan otherwise abusive as to justify denying
were approved it would send a strongly shareholders the option to tender their
negative message to the investment com- shares if they so choose’.
munity that the board, which in Japan is The question is whether the courts will
usually controlled by management, can look objectively at Steel Partners’ record
choose the company’s shareholders. or pander to the public, which is against
‘Japan [would be] going back to the the US group.
dark ages. It will really depress the stock
market because what it effectively says is Note: additional reporting by David Turner.
168
I The analysis
In this case the Japanese company Bull-Dog Sauce was the subject of a hostile takeover bid
by the US hedge fund Steel Partners. Steel Partners had already built a 10.5 per cent stake
in the target company. It then offered ¥1584 for each remaining share which amounted
to a 20 per cent premium on the company’s stock market price at the time of the bid. This
10
was the latest bid by increasingly activist shareholders who were forcing some Japanese

companies to make moves which were designed to win favour with their shareholders.
This included increases in share dividends and some modernisation of their corporate
structure.
Following the move from the US hedge fund, Bull-Dog Sauce inserted a so-called
‘poison pill’ which would act as a strong disincentive to any bidder. The particular type of
poison pill being used here is a complex form of rights issue which was rather worryingly
termed a ‘SARS’ in Japan. In fact ‘SARS’ just stands for a special acquisition rights. So how
does this product work in practice?
The Bull-Dog Sauce rights issue is very different from a normal corporate rights issue.
True, it will allow shareholders to purchase additional shares in the company. However, this
will be achieved via an issue of warrants. This is a financial instrument that gives the holder
the right to purchase financial market securities from the issuer at a set price. In this case
they will allow all Bull-Dog Sauce’s shareholders, except Steel Partners, to buy new shares
in the company at just ¥1 per warrant. Every shareholder, including Steel Partners, will
receive three warrants per share. However, Steel Partners alone among the shareholders
will not be able to trade their warrants in for shares. Instead they will receive ¥396 per
warrant. This is a best-case scenario because, while Bull-Dog Sauce ‘reserves the option of
converting Steel Partners’ warrants into cash . . . [it] has no obligation to do so’. So it is
possible that their warrants will turn out to be valueless instruments and, more import-
antly, due to the extra shares that have been issued, if this poison pill is allowed to take
effect Steel Partner’s equity stake will fall from 10 to 3 per cent.
This raises the big question of whether this process is legal in Japan. It would seem to
violate the principle that companies should treat all shareholders the same. Within Japan, the
Financial Times quotes Steel Partners as suggesting that the scheme represents “a discrimi-
natory act . . . in violation of Japanese law”, which it says states that ‘“a company should
treat shareholders equally according to the contents and amounts of shares that they have”’.
The Financial Times article expresses the fear that if this poison pill is allowed to stand it
will seriously damage the Japanese Financial Services Industry. It might well undermine
confidence both among domestic and international investors. Indeed the head of Japanese
mergers and acquisitions at a leading western bank is quoted as saying if the court
approves Bull-Dog’s measure, ‘it’s the end of the Japanese capital market’.
Finally, the article seems to suggest that Bull-Dog Sauce’s poison pill will only be
allowed by the Japanese courts if they regard Steel Partners to be acting as a Greenmailer.
This is where a company deliberately sets out to mount an unwanted takeover bid in order
to force the target company to buy their equity stake at a significant premium. Foreign
companies rarely bid for Japanese companies and therefore this move from a US hedge
fund might well be seen as coming from just such an unwanted ‘corporate raider’.
169
I Key terms
Poison pill When a company is subjected to an unwanted takeover bid, there are a number of
measures that they can take to try to defend themselves. One such technique is called a ‘poison
pill’. This is where a company introduces some measure that will seriously damage the interests
of the company making the takeover bid. This might, for example, be an issue of a new bond
which following a takeover bid would give the bond holders the option to redeem their bond
immediately at a significant premium to its par value. This will act to deter any bidder.
Tender offer This is simply where the takeover bid is made through a public offer which is
open to all shareholders allowing them to sell their shares at a price that is usually well above
the current market price.
Annual general meeting (AGM) All public companies must invite their shareholders to an
AGM to vote on a number of important issues. This will include the approval of the annual
report and accounts, the re-election of the directors and the dividend level.
This is the key forum allowing the shareholders to express their views to the managers of the
company. For example, in recent years it has allowed some pressure groups to exert pressure
on companies involved in the arms industry or other so-called ‘unethical’ sectors.
Rights issues This is where a company issues some additional shares on a pro rata basis to
existing shareholders. The new shares are normally sold at a discount to the current market
price. These issues provide no access to new shareholders.
Normal rights issues are popular because they can be made at the discretion of the board of
directors. The shareholders like the discounts available and they leave the balance of voting
rights unchanged.
Warrant This is a derivative instrument that gives the holder the right to purchase financial
market securities from the issuer at a set price within a certain time period. They are commonly
attached to certain new bond issues giving the holder the right to buy some shares in the
issuing company. They were used a great deal in the 1980s when international investors were
very keen to buy Japanese shares.
Greenmailer This refers to a very unusual situation in corporate takeover bids. It is where one
company (the takeover company) deliberately builds up a large stake in another business (the
target company) and then appears to launch an unfriendly takeover. This whole process is
designed to force the target company to repurchase the stock at a substantial premium to
prevent a takeover bid.

1. Briefly describe the main defences that can be used by a company after its board has
received an unwanted take-over bid.
2. In the context of mergers and takeovers explain what is meant by a ‘poison pill’. Give
some examples of three poison pills that have been used in practice.
3. What is meant by the financial term ‘warrant’?
170
I Research
You should look at Chapter 12.
10

You will find mergers and acquisitions explained in Chapter 28.
Edition. Mergers, LBOs, etc. are covered in Chapter 17.
Financial Times. The topic of corporate restructuring is covered in Chapter 14.
Hall. You should look at Chapter 20 with p. 575 having a discussion of ‘poison pills’ as one of
many potential takeover defence tactics.
FT Prentice Hall. You should look at Chapter 11. Poison pills are explained on pp. 337–8.

171
Topic 11
Risk management and hedge funds
The last few years have seen a huge increase in interest in the concept of the many
types of financial risk and in particular how they can be managed. This is hardly
surprising in the light of the credit crisis and the resulting long list of bank failures across
the world. Before we look at the risks that banks face we should pause briefly to define
what is meant by the term ‘risk’ in the context of finance. Put simply, we define risk in
terms of the possibility of incurring some kind of financial loss. This is the natural flip-
side to the financial gains that are available in financial market investments. As we have
seen, earlier investors in shares must be willing to tolerate the much higher degree of
risk in order to give themselves a chance to make much higher gains than are available
on safer investments like bonds or cash deposits.
For risk-averse individuals the advice is to stick with low-risk and low-return investments
like government bonds or cash deposits in banks. In contrast, those investors who are
more tolerant of risk should go for more equity-related investments which have
historically offered the prospect of higher returns to compensate for their greater risk.
In this section of the book, in addition to the topic of risk, I have decided to include an
extra section on the role of hedge funds. There are two reasons for this. First, they are a
perfect example of a financial institution that is strongly associated with the concept of
risk. Second, during my teaching I have found that this is one of the areas which elicit
most questions from students. They seem to be intrigued by the activities of hedge
funds.
The credit crunch showed us that the risks that banks face can have a very significant
impact on the wider economy. This is largely due to the perceived threat that, if one
bank goes under, it will almost inevitably result in other banks failing. This so-called
‘domino effect’ was the great fear that forced governments across the globe to spend
billions in support of their domestic banking systems during 2008. These fears explain
the heightened public concern that centres on bank failures and the resulting trend
towards even tighter regulation of the activities of banks.
So what are the major types of risk facing banks?

1. Credit risk. This is the risk that a party to a financial contract fails in some way to
fully discharge the terms of the contract. In the case of banks this form of risk is most
strongly linked to their lending activities. The credit risk refers to the possibility that
the bank will not see these loans repaid in full. In addition to this form of credit risk
there is also a strong link to the banks’ tendency to hold a wide range of financial
assets. A perfect example would be where a bank owns a bond market instrument
and the issuer of that financial market security fails to make timely payments of
interest or the principal on the maturity date. We can also call this ‘default’ risk. In
the Financial Times ‘High-Yield & Emerging Market Bonds’ table you will see the use
of the symbol ‘DEF’ next to a bond issuer to signify that they are in default. This was
sadly the case for Argentina’s emerging euro-denominated issue in October 2008.
In order to counter this form of risk, the banks will use the services of the
various credit-rating agencies (including Moody’s and Standard and Poor’s). Their
function is to assign credit ratings to various bond issuers. This acts as a measure
of the risk that they will default on the terms applying to the issue. The highest
credit rating allocated by Moody’s is triple A (AAA) which indicates the issuer’s
‘capacity to pay interest and principal is extremely strong’. The banks will typi-
cally also employ their own in-house credit rating teams to provide another view
on this form of risk.
2. Market risk. This occurs where there is the possibility that the prices of a financial
market security may decline over a period of time due to any general economic
factors or some other change in market conditions. As an example, a bank might be
the holder of a significant number of shares in a particular airline. They are likely to
see a sharp decline in the financial value of these holdings if an economic downturn
results in the need for the airline to lower profit margins in order to prevent a large
loss in passenger numbers.
3. Interest rate risk. As we have seen earlier, banks hold a wide variety of financial
assets. The value of these securities is likely to change following any movement in
interest rates. For example, the price of government bonds would be expected to fall
in reaction to any increase in interest rates. This price fall will maintain the com-
petiveness of their yields compared to the higher level of interest rates.
4. Liquidity risk. In financial markets this term refers to how easily an asset can be
turned into cash. Notes and coins are the most liquid financial assets. Liquidity risk
occurs when the holder of an asset is prevented from being able to realise the full
value of it when they need to sell. For example, a bank might be forced to offer a
significant discount when they become forced sellers of a large number of financial
market securities in order to raise additional finance. This is a very important form of
risk for banks as they will be required to keep a large amount of liquid assets to
cover their day-to-day needs. In practice, the demand from their customers for cash
will be fairly predictable as they tend to only look to access a small percentage of
their total deposits held with the bank. If a particular bank experiences a higher than
normal demand for money, it can normally access extra liquidity by borrowing in
the inter-bank markets. It was only when this market effectively stopped functioning
during the credit crunch that a number of banks got into severe financial
difficulties.
5. Operational risk. The efficient operation of the banking system is increasingly
dependent on complex computer systems. This form of risk comes into play when a
failure in a bank’s systems results in some kind of financial difficulty. In the US the
Federal Reserve Bank makes emergency loans available to any qualifying banks that
are facing these sorts of technical difficulties.
174
6. Fraudulent risk. Sadly, all banks face the risk that one person or a group of their
employees will engage in some activity that causes them a significant financial loss.
For example, in early 2008 the news broke that a single rogue trader had lost Société
Générale €4.9 bn (£3.7 bn) in fraudulent futures trades.
7. Exchange rate risk. This is the risk that a bank might incur as a result of adverse
movements in foreign exchange rates. This is a major issue for many banks, because 11
they tend to hold large amounts of foreign currency assets and liabilities in their
RISK MANAGEMENT AND HEDGE FUNDS

balance sheets.
8. Legal risk. This is the risk that arises from any contracts that a bank finds impossible
to legally enforce. As a result the business of the bank could be significantly inter-
rupted.
9. Systemic risk. This is the risk that the entire financial system might face the possi-
bility of contagious failure following the collapse of one particular bank. The worry is
that the collapse of this bank starts to have a domino effect which impacts on other
banks in the system.
Banks are associated with many different types of risk. In the above discussion these
rights have been identified as separate and independent, but in practice they will be far
more interrelated. For example, if there is a sharp increase in interest rates (interest rate
risk) this is likely to lead to many more loan defaults (credit risk). In the light of the
recent credit crisis it is not surprising that banks are now putting huge resources into
attempts to manage the many risks that they face.
Another financial institution that involves large amounts of risk are hedge funds. One
key characteristic of many of them is their innate secrecy. You will have a long search if
you are hoping to see adverts for their services on TV or radio or in the popular press
unless you are reading Millionaires Weekly. The reason for this is that they focus on high
net-worth individuals to provide their client base. The hedge funds have been around for
a surprisingly long time with their origins going back to the early 1940s primarily in the
USA. The first time I came across them was when one of their star names, George Soros,
made a financial killing at the expense of the UK government when sterling exited the
exchange rate mechanism in September 1992.
So what do they do? In essence their business model is quite simple. They look to raise
sizeable amounts of cash from wealthy individuals and then invest this money in almost
anything that they believe will make them profitable. So, in many ways they are rather
like any normal fund manager who looks to invest cash for the financial benefit of their
unit holders. However, there are two important differences. I will set these out briefly
here and develop these themes in the analysis of the related article later.
1. They tend to take far more risk with their investments, often employing some
unusual investment strategies. For example, they are heavily associated with the
practice of short selling. This is where a hedge fund would sell shares that they do
not yet own. In other words they have not yet made an offsetting purchase. This is a
very risky activity because, if the price of the financial market security rises, the
175
hedge fund will have to pay an ever higher price to secure the stock. In this case the
traders are betting on the shares falling in price. For example, they might sell 1
million shares at £5. If the share price now falls to £4 the fund makes £1 m.
However, if instead the share price rises their risk is infinite.
2. They charge very high fees for their services. This is normally taken as a percentage
of the profits made by the fund. So, if a particular hedge fund makes a profit of
£300 m for their clients, do not be surprised to see the owners of the fund take
20–30 per cent of this cash to share between themselves. In good times hedge fund
managers can get seriously wealthy very quickly.
In this section of the book I have included two articles. The first focuses on the well-
established topic of the impact of foreign exchange rates on companies. In contrast, the
second article looks at the relatively new area of hedge funds. In this article you will
clearly see that hedge funds attempt to maximise their returns but often at the cost of
much greater financial risks for their fund holders. I have also tried to give a clear guide
to the main activities and investment strategies of hedge funds.
Article 31
Exporters curse dollar’s drag on profits
Article 32
Facing down the threat of tighter rules
Financial Times, 20 June, 2007

I types of currency risk;
I economic risk;
I translation risk;
I impact of currency movements on dividends;
I role of hedge funds;
I investment strategies of hedge funds;
I long-short equity;
I activist hedge funds;
I macro-trading strategy;
I regulation of hedge funds.
176
The $2 pound puts pressure on UK

companies
The Financial Times has over the years traced the rise and fall of the pound on the foreign
exchange rate markets. As a survivor of numerous sterling crises in the 1980s and early
11
1990s it has always seemed to me that it has done far more falling than rising. Indeed the

article makes reference to the famous day on Wednesday 16 September 1992 when the
UK government gave up trying to defend the pound’s value in the old exchange rate
mechanism. The Chancellor allowed interest rates to go back to a more reasonable level
and the pound fell sharply. It was the day when the media claimed that the international
financier George Soros called the Bank of England’s bluff and the Bank blinked first.
Almost 15 years later (can it really be that long ago?) this article looks at the subject of
corporate foreign exchange rate risk. It examines how the UK economy is being affected
by the advent of the $2 pound. Even more telling is the perspective of the individual
companies who are dealing with the daily problems of living with a pound that has
appreciated so strongly against the backdrop of a very weak dollar.
Exporters curse dollar’s drag on profits

Chris Hughes
The pound’s strength against the dollar is markets are at a competitive disadvantage
a boon for British consumers planning if their cost base is located in the UK and
luxury mini-breaks to New York. But denominated in sterling. The weak dollar
some UK companies are cursing the toll crimps their revenues, but wages still
the exchange rate is taking on their have to be paid in pounds. That creates a
profits and competitiveness. painful squeeze
The issue came to prominence last Second, companies that serve US
month when the pound breached $2 for markets through local operations will see
the first time since the UK withdrew from dollar costs and dollar revenues move in
the exchange rate mechanism in 1992. In tandem, but their dollar profits still take a
fact, the currency has been strengthening hit when converted into sterling.
steadily over the past five years, and Finally, the exchange rate reduces the
especially the past nine months. sterling dividends of companies that
About 22 per cent of the sales of the report their financial results in dollars.
FTSE-350 are directly exposed to the US, That applies to many large UK
while a further 11 per cent come from companies, such as GlaxoSmithKline, BP
regions closely tied to the dollar, according and HSBC.
to Citigroup. It is companies in the first camp that
So how is UK plc holding up? The are being hit the hardest. The strong
victims will fall into one or more of three pound is not just reducing the profits and
categories. First, exporters serving dollar dividends paid to investors. It is affecting
177
Article 31 Exporters curse dollar’s drag on profits
their long-term competitiveness and may from previous jumps in the pound, and
even lead to loss of market share to US or most UK companies remain more reliant
Asian rivals. on Europe than the US or Asia.
One such victim is Arm Holdings, the ‘Anecdotally, the strong pound is
Cambridge-based designer of semiconduc- putting pressure on profit margins but it
tors, an industry whose global currency is is not affecting volumes. UK companies
dollars. Warren East, chief executive, esti- lived with a strong exchange rate after
mates that the dollar has wiped £1 bn 1998 across the board. That led to a great
from the company’s stock market value. deal of efficiency improvements’, he says.
‘We are at the acute end of the scale. The ‘British industry is a little bit more com-
last three years have been pretty horrid’, petitive even at these exchange rates than
he says. ‘The only way you can respond is we feared.’
by matching your cost base [to the dollar]. As for the wider stock market impact, it
That means jobs going outside the UK. We depends where you look. Citigroup
have gone as far as we can and about 50 research has found that over the past six
per cent of our costs are now overseas.’ months, shares of companies with more
Arm has also taken advantage of rela- sales in the US have underperformed.
tively low-cost skilled labour in India. Meanwhile, looking at the market as a
Headcount there has risen from two to whole, Morgan Stanley estimates that for
230 since 2004. every 10 per cent rise in sterling against
‘There is a lot of intellectual capital in the US dollar, stock market dividend
the business that’s in Cambridge and will growth is reduced by 2.5 percentage
never leave. This is still very much a UK points. That means dividend growth this
company at heart’, Mr East says. year could be zero.
Meanwhile, other companies in a And are there any winners from the
similar position have responded by weak dollar? Clothing retailers such as
hedging – buying derivatives off banks Next benefit from cheaper textiles costs in
that offset the impact. CSR, the Bluetooth Asia, while much of the manufacturing
technology group, hedges about 40 per industry enjoys lower raw material costs,
cent of its cost base, fixing it on a rolling such as steel and chemicals.
12-month basis. The snag is that companies benefiting
Economists have nevertheless been sur- from the weak dollar may also come under
prised by the resilience of UK plc as a pressure to pass savings on to customers.
whole. The latest quarterly survey of Bauer Millett, a Manchester-based car
industrial trends by the CBI, the employ- importer, looks as though it is a sweet
ers’ organisation, found that export spot. Not so, says Chris Harris, one of its
orders were holding up well and company directors. ‘Yes, we have been able to buy
optimism about exports was at its highest US cars for less. But customers expect to
in two years. buy them at half price because that’s what
Ian McCafferty, chief economist at the they see in the headlines.’
CBI, says companies have learnt lessons
I The analysis
With the often wild movements in foreign exchange rates there are always some winners
and some losers. In the case of the pound rising in value against a weak dollar, UK con-
sumers delightedly head west in their masses to buy up all the goods that retailers such as
178
Bloomingdales and Macys can offer them. The losers are the many UK-based companies
which export to the US or to other parts of the world that have their exchange rates linked
to the dollar.
The reasons for the weakness of the dollar are not made clear in the article. There are
a number of theoretical models that are used to explain currency movements. In the
research section I have provided a reference to a very clear explanation of these theories 11
(see Pilbeam book). At this particular time there is no doubt that a major factor behind

the weakness of the dollar was the concern about problems in the US mortgage market
which it was feared would cause a slowdown in the world’s largest economy. Against this
background the Fed was expected to keep its key short-term interest rates unchanged,
while in contrast we were seeing increased interest rates in both the eurozone and the
UK. The foreign exchange markets were focusing on the resulting change in the interest
rate differential between the US and these European markets. Investors were being
attracted by the higher interest rates available in both the euro and sterling money
markets and were selling dollars fast as they liquidated their US money market invest-
ments. The expectation that other key central banks would increase interest rates while
the Fed held US rates steady was expected to result in a continued period of dollar
weakness.
The core of the article identifies three main types of currency risk that face corporate
treasurers. The first is economic risk, which is caused by the rising value of the pound
making all UK goods and services more expensive when they are being sold into the
dollar-based markets. In effect it is the reverse impact of UK consumers flocking to buy
cheaper goods in US stores. Now at $2 to the pound US customers will look elsewhere for
much cheaper merchandise, which results in the UK companies losing market share to
companies based in other countries which have not seen their exchange rates appreciate
against the dollar.
This article relates this economic risk to the UK-based company Arm Holdings plc. The
Cambridge-based company designs semiconductors; this is an industry that almost more
than any other is dollar-based. Their chief executive is quoted as saying that ‘the dollar has
wiped £1 bn from the company’s stock market value’. Companies respond to economic
‘exchange rate risk’ by keeping their prices as competitive as possible, which means
keeping a firm hold on their cost base. Labour costs are pivotal, so Arm Holdings have
sought to relocate some jobs to India with the company’s labour force there rising from
just two in 2004 to currently 230.
The Financial Times article reports that other companies in a similar position to Arm
Holdings have attempted to offset the impact of sterling’s rise against the dollar. They have
looked to employ the various sophisticated hedging techniques which are on offer from
the banks. These can be used to minimise some of the economic risk. The downside is that
they are very expensive and they do not always suit this type of risk that is by its nature
very uncertain.
The second type of currency risk is translation risk. This occurs where companies that
supply the US markets through local operations will see their dollar revenues and costs
move together. So far so good; however, the companies will take a financial hit when their
dollar profits are finally converted back into sterling.
179
As an example, if we have a UK-based company that has a US-based subsidiary to deal

with the United States market. It is successful and generates profits of some $200 m
per year.
Where the exchange rate is £1 ⫽ $1:

These $200 m profits will translate into £200 m for the UK accounts.
However, where the exchange rate is £1 ⫽ $2:

The same $200 m translates into just £100 m for the UK accounts.
The final type of currency risk discussed here applies to those companies that report
their financial accounts in dollars. There is a direct impact on the sterling value of divi-
dends announced in dollar terms. The rise in the value of the pound against the dollar
reduces the value of the dividends received in terms of the local currency. This applies to
a number of the biggest UK companies including GlaxoSmithKline, BP and HSBC.
The article moves on to express surprise that, despite these examples, the UK economy
as a whole has been remarkably resilient in the face of the appreciation in the pound. The
most recent CBI industrial trends survey shows that export orders are holding up well and
optimism about future exports remains strong. Its chief economist thinks that ‘companies
have learnt lessons’ from the past and that they have protected themselves by strong
efficiency gains. The resulting reduction in UK costs has countered some of the negative
impact of an appreciating pound.
In addition, the article points out that UK companies have reacted to sterling’s appreci-
ation against the dollar by looking to sell more to other markets such as the rest of Europe
and Asia. This is a perfectly viable strategy in this case as the dollar was generally weak
against these other currencies as well. This means that all other exporters to the US were
facing the same problem of their currencies appreciating against a weak dollar. Therefore,
they were all losing competitive advantage, which means that UK exporters were not
losing out compared to other international exporters selling to the US. They were all losing
competitiveness against US producers.
The article ends with a useful attempt to quantify the impact of currency movements
on dividends. They cite Morgan Stanley estimates that for every 10 per cent rise in ster-
ling against the US dollar, stock market dividend growth is reduced by 2.5 percentage
points. Despite this gloomy assessment there are some more winners. These are the UK
companies that see a sharp fall in the costs of their raw materials which are priced in
dollars. Companies like Next, for example, will be paying much less for textiles coming in
from South-East Asia. However, their customers will be demanding ever lower clothes
prices, otherwise they will be heading back across the Atlantic again with their empty suit-
cases!
I Key terms
Exchange Rate Mechanism (ERM) In the days before the existence of a single European cur-
rency there was a very complex system set up to control exchange rate fluctuations between
180
participating currencies. For a very brief time the UK became part of this system and this caused
severe problems for the UK economy which was then in recession. The government had to keep
interest rates very high in the middle of this downturn in a vain attempt to defend the pound’s
value. This policy came to a dramatic end on Black Wednesday in September 1992. The pound
crashed out of the ERM and interest rates fell sharply.
Currency risk This comes in three main types: transaction, translation and economic (see 11
below).

Transaction risk This is the risk associated with a particular financial commitment entered into
by a company that will involve a currency transfer. For example, if a UK company borrows
money in the US dollar and it is committed to make interest payments in dollars they are
exposed to transaction risk. So that each $1000 interest payment will cost £500 at an exchange
rate of £1 ⫽ $2. However, if the pound falls sharply in value so that £1 ⫽ $1, the $1000 interest
payment will now cost £1000.
Translation risk This applies to multinational companies which see their consolidated financial
accounts being affected by exchange rate movements. This might occur when a company has
various overseas subsidiaries and exchange rate volatility impacts on its consolidated accounts
when the subsidiaries’ figures are combined into the group’s overall financial results.
Economic risk This is caused by exchange rate movements impacting on the competitiveness
of a company. Put simply, if a company’s home currency appreciates, this will make it less com-
petitive as its goods and services become more expensive in overseas markets. It is normal to
see economic risk described as being a much more general risk than either transaction or trans-
lation risk.
Hedging This term is widely used in financial markets to indicate that an investment in a
financial market product is being made to minimise the risk of any unfavourable movement in
the price of a particular financial asset. In the context of the foreign exchange market hedging
refers to the process of a company attempting to protect itself against an adverse movement in
the foreign exchange market. The most commonly used hedging technique in this context is
the forward foreign exchange market. When a company is concerned about foreign currency
risk, it can use the forward market to sell or buy in advance a specific amount of currency at a
fixed rate on a specific date in the future. This is suitable if a company knows with 100 per cent
certainty the amount of foreign currency they will need to buy or sell on that particular date.
FTSE indices First we have the FTSE 100 index. This is the most widely quoted UK stock market
index. It is based on the value of the 100 largest UK companies in terms of their market capi-
talisation. It started with a base of 1000 in January 1984.
Second we have the FTSE 250 index. This is simply an index of the next 250 companies in
terms of their market capitalisation.
And then we get to the FTSE 350 index. Put simply, it combines the FTSE 100 and the FTSE-
250 indices.
CBI surveys The Confederation of British Industry (CBI) is widely described as the employers’
organisation. It is a voluntary group made up of around 1500 UK-based manufacturing
companies. It carries out a wide range of surveys to gauge their members’ views on the current
state of economy activity. It provides a useful overview of the state of manufacturing industry.
181
The surveys are sent out at the end of each quarter and the results are published about three
weeks later.

1. Define the main types of risks faced by banks.
2. What is the difference between liquidity risk and a liquidity trap?
3. Explain what is meant by the term foreign exchange rate risk.
4. Describe the three main types of currency risk that impact on companies in the UK.
Give real examples in each case.
5. Companies have learnt lessons from the previous jumps in the pound and most UK
companies remain more reliant on Europe than the US or Asia.
‘Anecdotally, the strong pound is putting pressure on profit margins but it is not
affecting volumes. UK companies lived with a strong exchange rate after 1998 across
the board. That led to a great deal of efficiency improvements.’
This paragraph is from the article with the quote from Ian McCafferty, chief economist at
the CBI.
You are required to explain what types of measures have been taken by UK companies in
recent years to protect themselves from these adverse exchange rate movements.
You will need the Companies and Markets section of the Financial Times. Go to the back
page.
Take a look at the Daily Markets Report. Find an example of a company’s share price that
moves as a result of a movement in the foreign exchange markets.
I Go to the web
Go the official website of GlaxoSmithKline: www.gsk.com.
Find the latest annual report. Look at the section titled ‘Financial position and resources’.
Scroll down to the section on foreign exchange risk management.
a. Write a short note on the types of currency risk faced by GlaxoSmithKline.
b. How does the company manage these risks?
182
I Research
should especially look at Chapter 25, pp. 969–91 to see more on the main types of currency
risk and how they can be managed.
You will find exchange rate risk covered on pp. 939–43.
11

Edition. There is a superb section on exchange rate risk on pp. 817–25.
Financial Times. The topic of foreign exchange is in Chapter 15. The various types of FX risk start
on p. 418.
Hall. You should look at Chapter 21, pp. 620–30 for a superb explanation of ‘transaction
exposure, translation exposure and economic exposure’.
Pilbeam, K. (2006) International Finance, 3rd edn, Basingstoke: Palgrave Macmillan. This has a
very clear introduction to the theories of foreign exchange rate determination. You should look
in particular at Parts 1 and 2 which cover the balance of payments theory and practice and
exchange rate determination: theory, evidence and policy.
Van Horne, J. and Wachowicz, J. R. (2008) Fundamentals of Financial Management, 13th edn,
Harlow, UK: FT Prentice Hall. You should focus on Chapter 24, pp. 641–55 for a comprehensive
coverage of exchange-rate risks.
FT Prentice Hall. You should look at Chapter 12. The key section is on pp. 365–6.
183
So tell me, what do these hedge funds

actually do?
It used to be the case that ambitious parents would dream of their kids becoming inter-
national sports stars scoring the winning goal at the San Siro or sinking the winning put
at Augusta to claim their third ‘green jacket’. This was their path to glory and financial
security. Sadly, these parents might soon start to dream of their offspring setting up a new
hedge fund because this seems to be the quickest route to joining the super-rich. We
might even see the ‘101 things you need to know about hedge funds’ replace Harry Potter
as the bedtime reading of choice.
But what is a hedge fund? In simple terms it is an extreme form of fund management.
Hedge funds raise a small amount of initial capital from investors and then borrow money
from financial institutions and take much greater financial market risks in the search for
spectacular returns both for their clients and also themselves. These funds are often on the
front pages of newspapers when they buy a stake in an underperforming company and
then demand major changes in their corporate strategy. The company’s senior managers
are axed and this is then followed by significant rationalisations of the business much to
the anger of the employees and the trade unions.
The hedge funds appear to be quite secretive. Certainly their websites contain very little
information about their activities. However, the one thing we know for sure is that the
amount of money managed by these funds is growing rapidly. It has been estimated that
there has been a growth of 25 per cent pa in the cash in these funds since the early 1990s.
Their attraction is obvious. In a rising market they can secure vastly superior returns by
using complex financial products to maximise their gains and they can even turn falling
markets to their financial advantage. Some governments have become concerned about
their increasing power and the potential risk that they pose to the world economic order.
The worry is that confidence in the financial system could be undermined if one of the
larger hedge funds went bankrupt. This article shows the response of the hedge fund
industry which is looking for voluntary controls rather than a system of strict official regu-
lation.
Article 32 Financial Times, 20 June, 2007 FT
Facing down the threat of tighter rules

James Mackintosh
When the biggest hedge funds in the But when 13 of the biggest European
world team up, the target is usually funds got together yesterday – supported
quaking in fear at the power wielded by by a score or more of smaller participants
the shadowy asset managers. – the move was defensive, intended to
184
Article 32 Facing down the threat of tighter rules
Working group members ‘comply or explain’ model from Britain’s

Brevan Howard, London. Nagi Kawkabani, CEO Combined Code on corporate governance.
Brummer & Partners, Stockholm. Klaus Jäntti, CEO The focus of the group is on valuation,
Centaurus Capital, London. Bernard Oppetit, CEO
disclosure and risk management, all areas
of concern to regulators.
Cheyne Capital, London. Stuart Fiertz, president
It got off to a good start. Before it has 11
CQS, London. Michael Hintze, CEO
even had its first formal meeting

Gartmore, London. Jeffrey Meyer, CEO
Germany, which has been pushing for
GLG Partners, London. Manny Roman, co-CEO
greater transparency in the industry, and
Lansdowne Partners, London. Paul Ruddock, CEO the European Central Bank, welcomed
London Diversified, London. Rob Standing, founding partner the move.
Man Group, London. Stanley Fink, deputy chairman Peer Steinbrück, German finance min-
Marshall Wace, London. Paul Marshall, chairman ister, said: ‘Naturally, I welcome the plan
Och-Ziff Capital, New York. Michael Cohen, Europe, CIO by the hedge funds on self-regulation. I
RAB Capital, London. Michael Alen-Buckely, chairman see it as a confirmation of our G8 trans-
parency initiative’.
head off an assault on the industry by reg- Germany’s G8 move was shot down by
ulators. other countries, particularly the UK and
Hedge fund managers have been US, which argued against more govern-
watching with increasing horror as pol- ment interference in the booming sector.
itical pressure on the private equity But it is far from clear that trenchant
industry has ratcheted up, particularly as critics of hedge funds – including left-wing
many critics lump hedge funds in with the politicians and trade unionists – will be
buy-out groups they accuse of pillaging satisfied by the group’s review.
companies and endangering jobs. Activist hedge fund attacks on under-
When Germany unsuccessfully tried to performing companies, which have led to
push the Group of Eight to tighten over- union protests and criticism of hedge
sight of the industry – already regulated funds as ‘locusts’ in Germany and
in Europe, but only lightly regulated in Holland, is unlikely to feature in rec-
the US – that prompted Marshall Wace, ommendations due next year, said Sir
one of London’s biggest funds, to start Andrew, who chairs MW Tops, the listed
calling rivals. hedge fund.
Sir Andrew Large, the former deputy The group is not likely to become a vol-
governor of the Bank of England who is untary regulator, or a self-regulatory body
heading the working group, said: ‘The G8 along the lines of the Securities and
may have helped to crystallise the process Investment Board, the Financial Services
but the recognition that something along Authority’s predecessor, run by Sir
these lines was desirable had been devel- Andrew for five years.
oping for some time. Hedge funds involved in the group have
‘The idea is really designed to enhance dismissed the idea, raised by Germany
confidence in the sector in the eyes of last year, of a global database of hedge
investors, in the eyes of supervisors, and fund holdings.
more generally.’ ‘You have to ask the question of disclo-
The funds will look at the various sure to whom, and about what’, Sir
guidelines issued by different groups, Andrew said.
such as trade bodies and regulators, and For now, the detailed results of the
either endorse them or come up with their review remain no more than specu-
own voluntary standards, using the lation.
185
But Sir Andrew is hopeful they could ‘If London hedge funds take the view
form the basis of standards not just for that this is a good way to go then I hope
the UK – where 80 per cent of European that others might feel that it could be a
hedge funds are based – but elsewhere, sensible way to go as well’, he said.
even though the review is focused on the
UK regulatory environment.
I The analysis
Many people reading this will be surprised to know that they are already hedge fund
investors. If you are working and you have a pension fund the chances are that some of it
will be invested in one of the big hedge funds. The best way to analyse this article about
the role of hedge funds is to answer five important questions:
1. What are hedge funds? Hedge funds have been around for some time but they first
came to prominence in the late 1990s when one particular fund got into financial
trouble. This was Long-Term Capital Management (LTCM) which had been set up by
the former head of bond trading at Salomon Brothers. LTCM borrowed huge amounts
from the banks to finance some complex trades in the government bond market. In
the wake of the Asian financial crisis they ran up huge losses of some $4.5 bn in 1998.
The New York Reserve Bank organised a rescue package involving many major financial
institutions which enabled the fund to close without too much of an adverse impact
on the world’s markets.
Although hedge funds are engaged in managing funds, they are very different from
a traditional pension fund. For example, they are judged in absolute terms, which is in
sharp contrast to normal investment funds which see their performance compared to
a standard benchmark like a stock market index (for example, the FTSE 100). It could
be argued that this makes more sense because a conventional UK equity fund manager
is seen to have done well if his fund falls by 20 per cent when the index he is tracking
has fallen by much more. This is precious comfort to a fund holder who reads his
annual report and sees a sharp fall in the value of his pension fund.
2. What investment strategies do hedge funds use?
(a) Long-short equity. How does this work? Let us take the example of the UK stock
market. Our hedge fund manager believes that the retail sector is overvalued and
it will correct itself shortly. He is especially sure that the share price of Tesco will
fall sharply. So he borrows some Tesco shares from a broker and then sells them
to a third party. If he is right the shares will soon fall in value. He waits for this to
happen and then buys them back at a much lower price. He can then return the
stock to the broker that he borrowed them from. The trick is that he buys back the
shares at a lower price compared to the price at which he sold the shares when
he borrowed them. The message is that the hedge fund can make money if Tesco’s
share price falls. With this strategy, if Tesco’s share price rises, he will lose money.
186
In reality, this is even simpler than it sounds as the financial engineers who work
in the City have designed special products that enable them to ‘take this bet’ in a
much easier way.
So hedge funds can make money from a falling market. In contrast, traditional
fund managers tend to either hold shares (if they think they will rise) or at best do
nothing, i.e. keeps their money in cash until they think the time is right. So the 11
hedge fund manager has a more flexible investment strategy and can do just as

well in a falling as a rising stock market.
(b) Activist hedge funds. Some hedge funds will take a large stake in a company and
become heavily involved in the day-to-day running of the business. They might
believe that the existing senior management team is making poor decisions and
so the hedge fund will seek changes. In short, they aim to ensure that the man-
agers of a public company are working every second of every day to maximise the
wealth of their shareholders. If you picked up the Financial Times almost any day
in the spring and early summer of 2007, you would find examples of activist
hedge funds in action somewhere in the world. No wonder the managers of busi-
nesses are afraid of hedge funds building up a stake in their companies. They
know that they will be under pressure to deliver superior returns to the share-
holders or face the sack.
(c) Global macro strategies. This investment strategy covers a wide range of high-
profile areas. The hedge fund manager might use various financial products to
take a bet on the next move in interest rates, exchange rates or oil prices. A good
example would be the Quantum Fund under the management of George Soros,
who made around $1 bn by betting that the UK government could not defend
the pound’s value against the Deutsche Mark in September 1992.
3. How do the hedge managers make their money? They charge substantial fees. This
includes a normal annual charge of 2 per cent per annum (management fee).
However, what is distinctive about hedge funds is that they also take a percentage of
any profits that they make from their investments (typically 20 per cent). This explains
the incredible level of returns for the partners in these funds. It is not unusual to see
them share annual bonus pools of some £400–500 million split between 30–40 part-
ners. This is not bad work if you can get it.
4. Why do the regulators want to control them? Much of the pressure for greater regu-
lation has come from the Group of Eight countries led especially by Germany, which is
looking to see far greater control imposed on the hedge funds. However, as the
Financial Times article says, ‘Germany’s G8 move was shot down by other countries,
particularly the UK and the US, which argued against more government interference
in the booming sector’. The concern from Germany is that hedge funds might pose a
threat to the global economy. One fear might be that, if they were to make substan-
tial losses and even fold like LTCM, this could have a domino effect on the whole of
the banking industry. It should be remembered that many banks have made substan-
tial loans to the hedge funds.
187
5. What controls are proposed? So far the leading hedge funds have tried to propose a
system of self-regulation in an attempt to fight off moves for more serious official regu-
lation. Under the chairmanship of Sir Andrew Large, former deputy governor of the
Bank of England, the hedge fund’s working group is to look into a system of voluntary
standards for the UK where the bulk of hedge funds are based.
I Key terms
returns or try to make gains even in a falling market. The fund will rely on large amounts of bor-
rowing and will use derivative markets and short selling to achieve these aims.
Fund managers The fund manager’s main role is to build a successful investment strategy
enabling them to optimise the value of the investment portfolio. They will have to monitor
financial markets and constantly assess market risks. In addition, they will have to communicate
their objectives with their clients.
Activist hedge funds This is very similar to an activist shareholder. An activist hedge fund
manager will target companies that are seen to be underperforming compared to their rivals.
They will then build up a stake in the business and use their power to demand significant
changes in the way the business is being run. This might include an attempt to oust the existing
managers or close down loss-making activities.

1. What are hedge funds?
2. What are the main differences between a hedge fund and a traditional pension
fund?
3. Outline three of the most popular investment strategies used by hedge funds.
4. Why is there growing pressure to see the hedge fund industry much more regulated
and controlled?
5. What impact would there be on the UK banking system if a number of large hedge
funds were to fail at the same time?
6. In March 2009 a number of hedge funds started to invest in gold. Many people saw
this as a way of betting against the policies being adopted by the central banks in
response to the economic downturn. The FT said at the time that ‘a bet on gold is a
bet against paper currencies’. Explain why gold might prove to be a good investment
if there was a serious risk that there would soon be a significant rise in worldwide infla-
tion due to the actions of the central banks.
188
I Research
This is a relatively new type of investment management, so there is only limited coverage so far
in the main corporate finance textbooks. The best place to learn more about hedge funds is
through reading the Financial Times regularly. There are articles most weeks on their perform-
ance and regulation.
Coggan, P. (2008) Guide to Hedge Funds: What they are, what they do, their risks, their advan-
11
tages, London: Economist Books.

Peston, R. (2008) Who Runs Britain and Who’s to Blame for the Economic Mess We’re /In, London:
Hodder Paperbacks.
Stefanini, F. (2006) Investment Strategies of Hedge Funds, Chichester: The Wiley Finance Series.

189
Topic 12
Bank failures featuring Northern
Rock and Citigroup
The first edition of this book was written largely against the backdrop of the economic
boom of 2006 and early 2007. This accounted for the optimistic articles on investment
banking, private equity and hedge funds. It was a time of ever-rising City bonuses when
the Labour government embraced the importance of the City to the UK economy. The
one exception was the topic based on the demise of Northern Rock, which was a late
addition in the last few months before publication. In many ways that topic is the bridge
that takes us into this new updated edition which inevitably reflects the economic
recession. One strange anomaly of this period is that, though there were some corporate
bankruptcies (such as Woolworths covered in Topic 6), given the severity of the
downturn relatively few companies went bust. Indeed, if you examined the constituents
of a major stock market index from mid-2007 and compared it to the same one in mid-
2009, you would find the names looked very similar.
The one exception to this would be in the banking sector, which went through a period
of unrivalled consolidation and change. The banks that led the rush into reckless
mortgage lending either went bust or had to be saved by another financial institution or
the government. There was an almost total collapse of confidence in the banking system
internationally which resulted in the rush of bank failures. A number of iconic banking
names disappeared forever, and it became clear that the general public would never
fully trust their banks and the promises they made ever again.
Some of the bank failures

Lehman Brothers fails.
Northern Rock nationalised.
Bradford and Bingley nationalised.
Alliance and Leicester taken over.
AIG bailed out.
Royal Bank of Scotland (record losses of £24 bn in 2008) bailed out.
Bank of America bailed out.
Citigroup bailed out (partial nationalisation: the US government becomes largest
shareholder with a 36 per cent stake).
Merrill Lynch taken over.
HBOS taken over.
Freddie Mac and Fannie Mae both bailed out.
Lloyds TSB bailed out.
Bank failures featuring Northern Rock and Citigroup
In discussing this topic, I have chosen to focus on just two examples of bank failure in
order to highlight the reasons behind these catastrophic events and to analyse the role of
governments in trying to prevent the banks’ demise since it would have led to financial
and economic meltdown. We start by updating the story of Northern Rock, which still
provides important lessons about the problems caused when uncontrolled greed meets
an almost total absence of risk management. You can read more on risk in Topic 11.
In the first article we see the origins of the crisis in the sub-prime market in the United
States which led to the deepening credit crisis and its consequences for financial markets
across the world. In the second and third articles we focus on the repo and interbank
markets at a time when banks were no longer willing to lend to each other. In the fourth
article we see how the UK authorities were finally forced to act to save Northern Rock.
They realised that they could not allow a major bank to go bust. Such an event would
have had far-reaching consequences for the reputation of the UK banking system for
years to come. In the final article we complete the story of Northern Rock’s demise as
the UK government is finally forced to nationalise the business.
The second example of bank failure added to this topic examines the failure and
subsequent bailout of the Citigroup. In the analysis of this article we will see how the US
government came together with other parties to rescue a bank that was one of the
hardest hit by the ongoing credit crisis. It was a perfect example of a bank that floated
high in the atmosphere of euphoria and unrestrained growth prevalent in the first few
years of this millennium and then crashed to the ground as economies faltered and
financial markets crashed.
The following six articles are analysed in this section:
Article 33
Fresh turmoil in equity markets
Article 34
Repo market little known but crucial to the system
Article 35
Growing sense of crisis over interbank deals
Article 36
Bank throws Northern Rock funding lifeline
Article 37
Brown saw no other option
Article 38
US government agrees to take biggest single stake in Citigroup
192
Bank failures featuring Northern Rock and Citigroup

I the credit crisis;
I mortgage-backed securities;
I the sub-prime crisis;
I retail and wholesale deposits; 12
I the repurchase markets;
BANK FAILURES FEATURING NORTHERN ROCK AND CITIGROUP

I the interbank markets;
I structured investment vehicles;
I lender of last resort facility;
I the role of the Bank of England, Financial Services Authority and the UK treasury;
I the nationalisation of Northern Rock;
I preferred shares;
I sovereign wealth funds.
193
Bank 1: Northern Rock: the road to

nationalisation
At the start of 2007 if you had gone into the street and asked some random people to
name a UK bank, you would have found that very few mentioned Northern Rock. Unless,
that is, you carried out this survey on the streets of the north-east of England where it was
based. However, just a few months later this bank’s name became world famous almost
overnight. It came close to being the first UK bank to fail in almost 141 years. The media
revelled in capturing the daily drama as queues of worried savers waited patiently to
remove all their money from their accounts. Their fear was that it was about to fail, and
they were concerned that in such an event only the first £2000 of their savings would be
fully protected by the Financial Services Compensation Scheme (plus 90 per cent of
savings from £2000 to £35 000). Many of the savers had far more than this upper limit in
their accounts.
There is little doubt that the resulting panic at one stage threatened to undermine con-
fidence in the other banks and indeed the entire UK financial system looked at serious risk
of meltdown. Against that background the government, the Bank of England and the
Financial Services Authority were finally forced into action to shore up Northern Rock. On
the 17 September 2007 at 6 p.m. the Chancellor, Alistair Darling, came on TV and
announced that all savings at the bank would be 100 per cent protected. In the analysis
of these five articles we will see how the crisis developed and how it ended up with the
ultimate nationalisation of Northern Rock in February 2008.
Article 33 Financial Times, 11–12 August 2007 FT
Fresh turmoil in equity markets

Krishna Guha, Michael Mackenzie and Gillian Tett
Fresh turmoil gripped financial markets banks were able to continue lending to
yesterday with shares in London and each other at normal rates.
Europe suffering their worst one-day fall The moves marked the most radical
in four years and Japan also tumbling action taken by the US central bank to
sharply as the US Federal Reserve and calm markets since the aftermath of 9/11
other central banks scrambled to avert a and followed similar emergency moves by
liquidity crunch. the European Central Bank and the
As worries spread over deepening Japanese central bank in the past two days.
troubles arising from credit markets, the In another sign of its concern about the
Fed was forced to drop its ‘business as usual’ situation in the markets, the Fed started
stance to inject $35 bn (£17 bn) into the accepting high-quality mortgage-backed
financial system to stem the risk of crisis. securities as collateral for the entirety of
The Fed also promised to provide what- these funds – something it rarely deems
ever funding was needed to ensure the acceptable.
194
Article 33 Fresh turmoil in equity markets
These moves were apparently triggered Northern Rock, the bank, fell 9.6 per
by signs of faltering confidence in banks cent to 713.5p while hedge fund manager
worldwide, with financial stocks tumbling Man Group tumbled 9.1 per cent to 479p.
and interbank borrowing rates surging as The FTSE Euro first also suffered its
institutions became more nervous of worst day in four years, falling 3.04 per
extending credit lines to each other. Bank cent. In Asia, the Nikkei 225 Average 12
stocks sold off sharply, amid intense relinquished its gains for the year, falling

speculation over the extent of credit 2.4 per cent.
markets troubles. On Wall Street, the Dow Jones
In London, the FTSE-100 suffered its Industrial Average and the S&P 500
worst fall in more than four years. After tumbled sharply on opening trade but
losing 1.9 per cent in the previous session, were both set to close virtually flat.
the index slumped a further 232.9 points The radical Fed action yesterday calmed
– 3.7 per cent – to 6038.3. The FTSE-100 the mood in the US interbank market. At
has been the only major stock index so far midday, the effective Fed funds rate was
to officially ‘correct’ – having fallen more trading near its target level of 5.25 per
than 10 per cent from its June peak. cent, after surging earlier to 6 per cent.
I The analysis
How did the crisis in the credit markets start?
The downside of the increased internationalisation of financial markets is that an economic
event in one country can now have major consequences for financial markets and institu-
tions that are based in other countries. In this case the crisis at Northern Rock can be
traced to the United States. In the aftermath of the terrorist attacks in New York on 11
September 2001 the Federal Reserve Bank embarked on a series of interest rate cuts that
culminated in their main short-term interest rate, the Federal funds rate, hitting a low of
just 1 per cent in June 2004. The result of this easing in monetary policy was that the
economy boomed, fuelled by the availability of cheap credit. The housing market bene-
fited from these conditions with homeowners seeing sharp rises in house prices
throughout the country. Not surprisingly, this began to encourage more and more people
into the housing market in the search for capital growth. Some of these were lower-
income borrowers and the US banks were all too willing to lend to these groups that in
the past might have been considered to be too risky. This was the birth of the ‘sub-prime
lending market’ in the US. However, this boom soon gave way to bust as the Fed’s policy
went into reverse with a significant tightening in monetary policy and the resulting
increase in mortgage rates causing many homeowners to be forced into defaults on their
loans. In the wake of record repossessions the housing market crashed and the ‘sub-prime
crisis’ was born.
During summer of 2007 this new phenomenon started to hit the headlines across the
world as the problems in the US started to impact on other countries. The problem was
that these mortgages had been pooled together and sold as ‘mortgage-backed securities’
to international banks across the globe. This meant that it was not clear which of them
had the greatest exposure to the risks associated with the sub-prime crisis. In June Bear
Stearns, the US investment bank, were forced to admit that it had made $1.6 bn losses in
195
Article 34 Repo market little known but crucial to the system
its hedge funds which owned vast amounts of these sub-prime mortgage debts. In August
the French bank, BNP Paribas, had to suspend some of their investment funds that were
also exposed to these debts. Other large banks began to calculate their financial exposure
to this problem. Soon speculation mounted as the search was on for the banks at greatest
risk. Stock market investors were quick to liquidate their holdings in banking shares. In the
first article taken from August 2007 we see quite clearly the impact that this was having
on financial markets as the ‘liquidity crisis’ began to bite. As a result ‘the Federal Reserve
was forced ‘to inject $35 bn (£17 bn) into the financial system to stem the risk of a crisis’.
How did this crisis impact on Northern Rock?

In the wake of these developments international banks started to become concerned
about lending money to each other. Suddenly the interbank market, which is normally
seen to be an almost risk-free prospect, was perceived to be potentially highly risky. If one
bank lent a large amount of funds to another bank and that bank ran into severe difficul-
ties because of its exposure to the ‘sub-prime crisis’, there could be a significant risk of
default on these loans. The Federal Reserve attempted to calm fears in the interbank
market by promising to inject enough liquidity as was necessary ‘to ensure that the banks
were able to continue lending to each other at normal rates’. In addition, it began to
accept mortgage-backed securities as collateral for its short-term money market opera-
tions (called ‘repurchase’ operations). These actions did have the desired result in calming
the mood in the money markets with the effective Federal funds rate falling from 6 per
cent back to 5 per cent close to the Fed’s target level. However, in the equity markets there
were clear signs of nervousness with the FT-SE 100 index falling sharply to close at a little
over 6000. And there was a clear sign of things to come as one Bank’s share in particular
was hit. The shares in Northern Rock fell by 9.6 per cent to 713.5 p. The crisis at Northern
Rock was beginning.
Article 34 Financial Times, 11–12 August 2007 FT
Repo market little known but crucial to

the system
Michael Mackenzie
The repurchase, or repo, market is a little- rescue and flooded the financial system
known part of the financial system but it with cash. This was done to keep in
acts as a crucial safety valve in times of line with one another the actual and
stress. It enables the flow of cash between target overnight borrowing rates, such
central banks and financial institutions, as the US Federal Reserve’s Fed funds
providing the plumbing that keeps rate.
markets functioning smoothly. The Fed injects cash into the money
This week, as financiers faced higher market on a daily basis so that the effec-
overnight borrowing costs in the money tive rate stays near its present target level
markets, central banks came to the of 5.25 per cent. Early yesterday the effec-
196
Article 35 Growing sense of crisis over interbank deals
tive funds rate traded at 6 per cent as not accept mortgages as collateral for repo
banks demanded higher rates to lend to transactions but the move signals an
each other, and then fell towards 5.375 attempt by the central bank to alleviate
per cent after the Fed injected $35 bn financing fears.
(€26 bn, £17 bn) in two separate opera- Wall Street dealers are seeking the
tions. sanctuary of government bonds and are 12
This week, money market rates for selling their holdings of riskier assets

eurodollar deposits and commercial paper such as mortgages.
rose well above normal levels. That meant Traders said that if the financing prob-
banks, companies, insurers and hedge lems continued and the effective funds
funds that rely on using short-term rate remained above its target level, the
funding faced higher costs. Fed was likely to repeat repo operations
That pressure pushed the Fed funds until the market settled down.
rate higher, which, if sustained, could ‘Central banks can ultimately fix a liq-
imperil the economy. uidity crunch by shipping in boatloads of
In the Fed’s repo operation, dealers cash and they are effectively doing that’,
posted mortgage securities as collateral said Alan Ruskin of RBS Greenwich
and received cash in return from the Fed. Capital.
Next week, the dealers and the Fed will ‘There is very little doubt that they will
reverse the trade. Usually, the Fed does come through in the end.’
Growing sense of crisis over interbank

deals
Gillian Tett
As bankers have returned to their desks This trend is deeply unnerving for policy-
this week after the summer break, they makers and investors alike, not least
have been searching frantically for signs because it is occurring even though the
that the markets are gaining a semblance European Central Bank and the US Federal
of calm after the August turmoil. Reserve have taken repeated steps in recent
However, the money markets are weeks to calm down the money markets.
notably failing to offer any reassurance. ‘What is happening right now suggests
While the tone of equity markets has that the moves by the Fed and ECB just
calmed, the sense of crisis in the inter- haven’t worked as we hoped’, admits one
bank markets actually appears to be senior international policymaker.
growing – especially in London. Or as UniCredit analysts say: ‘The
In particular, the cost of borrowing interbank lending business has broken
funds in the three-month money markets down almost completely . . . it is a global
– as illustrated by measures such as ster- phenomenon and not restricted to just the
ling Libor or Euribor – is continuing to euro and dollar markets.’
rise, suggesting a frantic scramble for If this situation continues, it could
liquidity among financial groups. potentially have very serious implications.
197
One of the most important functions of borrowing six-month or 12-month money.

the money markets is to channel liquidity ‘The system has just completely frozen up
in the banking system to where it is most – everyone is hoarding’, says one bank
needed. treasurer. ‘The published Libor rates are
If these markets seize up for any a fiction.’
lengthy period, there is a risk that indi- This situation could become increas-
vidual institutions may discover they no ingly dangerous in part because many
longer have access to the funds they need. other markets, such as swaps, are priced
This danger has already materialised off the three-month Libor and Euribor
for vehicles that depend on the asset- rates. So the interbank freeze could have
backed commercial paper sector – short- knock-on effects throughout the financial
term notes backed by collateral such as system.
mortgages. A more pressing problem is the large
In recent weeks, investors have increas- volume of asset-backed commercial paper
ingly refused to re-invest in this paper. due to expire in coming weeks, which is
As Axel Weber, a member of the ECB set to increase the scramble for cash by
council, admitted this weekend: ‘The the banks. ‘Money market stability needs
institutions most affected currently are to return as soon as possible’, says
conduits and structured investment vehi- William Sels, of Dresdner Kleinwort. Jan
cles . . . Their ability to roll these Loeys, of JPMorgan, notes: ‘The longer it
short-term commercial papers is impaired lasts, the greater the risk that the current
by the events in the sub-prime segment of liquidity crisis will worsen.’
the US housing market.’ The crucial uncertainty is what, if any-
This problem is affecting the wider thing, policymakers can do to combat the
banking system because these vehicles are sense of panic. Some observers hope the
now tapping other sources of finance – problems in the sterling market, at least,
mainly liquidity lines from banks. may dissipate when the current mainten-
It appears that the prospect of receiving ance period at the Bank of England comes
new liquidity demands has prompted to an end.
banks to rush to raise funds – and, above Others, such as Mr Weber, have
all, hoard any liquidity they hold. suggested that banks themselves need to
The high demand from banks to secure raise more funds in the capital markets to
liquidity for the next three months, meet liquidity calls. However, many
coupled with their desire not to lend out private sector bankers, for their part, say
what liquidity they have, has made it vir- that radical steps from the central
tually impossible to execute trades – even bankers are needed to remove the sense of
at the official prices quoted for such bor- panic.
rowing. Whether the central bankers are
That has created some extraordinary willing or able to really help – in the UK
dislocations such as the fact that the cost or anywhere else – remains the great
of borrowing three-month money in the question.
sterling Libor markets is now higher than
198
I The analysis
What role did the repo and the interbank markets play?
The repo, or to give it its full name the repurchase market, lies at the heart of the banking
system in most countries. The clearing banks are involved in a great deal of financial
activity each day that results in large amounts of cash flowing in and out of their accounts.
12
For example, if a large number of customers withdraw cash to spend in the shops through

their cashpoint cards, this will result in that bank seeing a significant reduction in liquidity.
At the same time another bank might see an exceptional number of customers making
cash deposits, which results in an increase in their liquidity. These daily cash imbalances
are not a serious problem and they are largely alleviated through the commercial banks
lending cash to each other to meet their short-term needs. This is done through the key
money market which is the London Interbank Offered Rate (Libor). There are times,
however, when the entire banking system requires a cash injection from outside. This is
where the repo market comes into centre stage. As Article 34 says ‘the repurchase, or repo,
market is a little known part of the financial system but it acts as a crucial safety valve in
times of stress’.
So how does a repo work?
Stage 1
The Central Bank

It has spare liquidity that it is willing to inject into the money markets
The Commercial Bank

It needs to make up a liquidity shortage by borrowing money.
It has plenty of collateral available in the form of high-quality government bonds.
Stage 2
The Central Bank

Announces the availability of a 14-day repo facility at a fixed interest rate.
This means that it will make a short-term (14-day) purchase of high-quality govern-
ment bonds from a commercial bank.
The Commercial Bank

It makes a short-term (14-day) sale of £500 m of government bonds to the central bank.
Stage 3 (in 14 days’ time)
Central Bank
It sells back the £500 m of government bonds to the commercial bank at the same price
that it paid for them plus an additional amount equal to the repo rate on the 14-day loan.
The Commercial Bank

It is obliged to repurchase the £500 m of government bonds from the central bank
and in addition pay an extra amount equal to the repo rate for the 14-day loan.
199
Article 36 Bank throws Northern Rock funding lifeline
One key function of these repo operations is to ensure that money market rates stay close
to the central bank’s desired target level. As Article 34 says: ‘The Fed injects cash into the
money market on a daily basis so that the effective [Fed fund] rate stays near its present
target level of 5.25 per cent’. However, the impact of the credit crisis began to spread into
the interbank markets with the effective Fed funds rate hitting 6 per cent as the banks
became increasingly reluctant to lend to each other. Effectively for a period in late August
and early September 2007 the interbank markets stopped functioning. This is clear from
Article 35 which reports that ‘the cost of borrowing funds in the three-month money
markets – as illustrated by measures such as sterling Libor or Euribor – is continuing to rise,
suggesting a frantic scramble for liquidity among financial groups’. There was particular
unease about these developments as the problems were continuing in the interbank
markets despite strong measures being taken by the Fed and the European Central Bank
in an effort to restore normal trading in these markets.
This had very serious implications because of the number of financial institutions and
markets that were dependent on this form of short-term funding. The world economy
faced the risk of a sudden collapse into recession if the liquidity in the money markets con-
tinued to drain away. As Article 35 notes, there were serious concerns especially in the
markets for commercial paper, short-term asset-backed securities, as investors become
reluctant to re-invest in these instruments. Liquidity in the banking system was virtually
non-existent with banks unwilling to lend funds, while at the same time they were desper-
ately searching for additional three-month borrowing themselves. As a result, even the
published interbank interest rates were largely irrelevant as traders could not execute deals
at these levels.
The key question facing financial markets at this time was whether the central banks
would be able to inject enough liquidity to restore normal trading in the money markets.
As Article 35 puts it: ‘Whether the central bankers are willing or able to really help – in the
UK or anywhere else–remains the great question’. This would soon be answered.
Bank throws Northern Rock funding

lifeline
Peter Thal Larsen and Neil Hume
The Bank of England will on Friday throw to bail out Northern Rock by providing
a lifeline to Northern Rock by providing it with a short-term credit line that will
emergency funding to the beleaguered allow it to carry on operating. The
mortgage lender that has fallen victim to rescue, approved by the Chancellor of
the liquidity squeeze in the banking the Exchequer, is the most dramatic
sector. illustration to date of how the British
In an unprecedented move, the Bank, banking sector is being hit by the wave
working with the Financial Services of turmoil that has paralysed the money
Authority and the Treasury, will step in markets.
200
It will lift the uncertainty that has been building society in the north-east of
hanging over Northern Rock’s future for England to become the most efficient
much of the past month because it could mortgage lender in the UK, winning wide
not access the wholesale funding upon praise for its business model and its
which it is heavily dependent. The Bank is ability to take advantage of the innova-
also expected to reassure thousands of tions in the capital markets. 12
Northern Rock’s customers that their The bank is set to issue a trading

deposits are secure. update on Friday describing the impact of
Northern Rock is the first institution to the recent market turmoil on its business.
be propped up since the Bank, in 1998, Northern Rock, the Bank of England,
revised the rules under which it will act as the FSA and the Treasury all declined to
a lender of last resort to banks in financial comment.
difficulty. The Bank is expected to say on Since hitting their peak in February,
Friday that a similar facility is available to shares in Northern Rock have lost half
any other institution facing short-term their value amid concerns that the rising
difficulties. However, it is understood that cost of wholesale funding would squeeze
no other banks have asked for financial margins and limit the bank’s growth. On
support. Thursday, the shares closed down 33 p, or
The Bank is understood to be confident 4.9 per cent, at 639 p.
about the quality of Northern Rock’s The turmoil will fuel speculation that
mortgage book, which has no exposure to Northern Rock could end up being taken
sub-prime borrowers and which will over by a bank with a larger retail
provide collateral for the emergency funding base. The bank, which derives
facility. But the bank, one of the UK’s almost all its revenues from the UK
largest mortgage lenders, has proved par- market, would be an attractive takeover
ticularly vulnerable to the liquidity target for several UK lenders or
squeeze because it has a smaller deposit European banks seeking to establish a
base than other lenders. foothold in the UK. However, any buyer
Northern Rock approached the Bank at is likely to take a careful look at
the end of last week to discuss using the Northern Rock’s balance sheet before
facility, people familiar with the situation making an offer.
said. The bank made its decision because About a quarter of Northern Rock’s
it faced pressure to refinance obligations, balance sheet is funded by retail deposits,
including mortgage-backed securities that with the rest coming from various sources
will mature in the next couple of weeks. of wholesale funding.
Northern Rock executives are expected It raised £10.8 bn in mortgage-backed
to say on Friday that it will try to trade securities in the first half of the year. But
through its difficulties with the help of the any further securitisation is thought to
Bank of England facility. be on hold until market conditions
However, the move is likely to make it improve.
harder for Northern Rock to remain inde-
pendent.
The bail-out is a devastating blow for
the bank, which grew from its roots as a Note: additional reporting by Neil Hume.
201
I The analysis
How did the government and the Bank of England act to save
Northern Rock?
The growing crisis in the world’s financial markets increasingly focused on one UK bank in
particular. That bank was Northern Rock, which had enjoyed a rapid rise since its stock
market flotation in October 1997. The obvious question is: why did it impact on that bank
especially? The answer is that they had a particularly aggressive business model. Unlike
other banks that get most of their funds from their savers, Northern Rock had raised its
finance largely from the financial markets. As the Financial Times article says, ‘About a
quarter of Northern Rock’s balance sheet is funded by retail deposits, with the rest coming
from various sources of wholesale funding’. In the first half of 2007 this amounted to some
£10.8 bn in mortgage-backed securities. This is where large amounts of mortgages are
pooled together and then sold on in the form of financial market securities. They made up
any short-term funding needs by accessing the wholesale money markets. In the wake of
the credit crisis both these avenues of funding were effectively shut down. Northern Rock
had run out of cash and it was heading into a financial meltdown.
The story was finally broken by Robert Peston, the BBC’s business correspondent, on 13
September on the BBC’s News 24 service. The next day queues started to form outside all
their branches as worried customers tried to remove their cash deposits. The fourth
Financial Times article in this case study reports that ‘The Bank of England will on Friday
throw a lifeline to Northern Rock by providing emergency funding to the beleaguered
mortgage lender that has fallen victim to the liquidity squeeze in the banking sector’. The
article discloses that in a unique operation the Bank would be combining with the
Financial Services Authority and the Treasury in an attempt to reassure investors and to
stop any further casualties among the UK banking industry.
The Bank’s lending to Northern Rock comes under its key function as ‘the lender of last
resort’. This means that if a bank is in financial difficulty it can always go to the central
bank to obtain emergency funding. Despite this intervention by the Bank of England the
queues continued to grow each day. Finally on the 17 September at 6 p.m. in the evening
the Chancellor used the opportunity of a televised press conference with the US Trade
Secretary, Henry Paulson, to make an announcement that the government had agreed to
guarantee all the deposits held at Northern Rock. This action effectively ended the run on
the bank and the queues outside their branches gradually disappeared. In a twin move a
few days later the Bank of England announced that it would inject £10 bn into the UK
money markets to try to reduce the cost of interbank borrowing. It also allowed, for the
first time, banks to use a wider group of assets to act as collateral for these loans, including
mortgages. In the immediate term these actions calmed savers and rebuilt some confi-
dence in financial markets. However, there were longer-term worries that the actions of
the UK authorities in bailing out Northern Rock might have encouraged other banks to
attempt to adopt a similarly risky business model. This is termed ‘moral hazard’ and it is
quite possible that this had been injected into the financial system, but in reality the gov-
ernment and the Bank of England had little choice but to act. The risk of a major UK bank
going bust was simply too great for any government to take.
202
Article 37 Brown saw no other option
Brown saw no other option

George Parker and Peter Thal Larsen 12

Gordon Brown took the agonising more in return for a government-backed
decision to nationalise Northern Rock at bond issue. Sir Richard could not offer
around 2 p.m. in Downing Street yes- more.
terday after he and Alistair Darling Even if Virgin met Treasury conditions,
concluded there was no other option, it might have had to tweak its plan to
write George Parker and Peter Thal reflect changes required by state aid auth-
Larsen. orities in Brussels.
Mr Brown’s verdict came even as one of There may have been other concerns.
the bidders, the bank’s management According to people close to the nego-
team, was still answering questions about tiations, the prime minister was reluctant
its proposal on Sunday morning. The to nationalise Northern Rock but feared
management group and Sir Richard the Virgin bid would amount to delayed
Branson’s Virgin consortium had sent in nationalisation because shareholders
final bids on Friday night, having had would reject it. Whitehall officials dispute
earlier offers rejected. this.
Goldman Sachs, the government’s Mr Kingman decided late on Saturday
advisers, realised the bids still failed to that the private sale option had run its
offer good value for money for the tax- course. ‘Goldman Sachs came to the same
payer. Virgin came closest to matching the conclusion’, said a government insider.
Treasury benchmark. Virgin was told not to bother supplying
The Treasury negotiating team, led by any new information.
one of its top officials, John Kingman, Ron Sandler, lined up to run the
went back for more. Virgin was told it nationalised bank, only learned he had
would have to give the taxpayer a greater got the job on Sunday afternoon.
share of any upturn in fortunes and pay
I The analysis
The final stage: nationalising Northern Rock
Following the bailout of Northern Rock their chief executive, Adam Applegarth, resigned
from his position on the 16 November 2007. At this stage the clear aim of the government
was to identify another private-sector group that was willing to pay a high price for the
business and also to offer a speedy plan for the government’s loans to the beleaguered
bank to be repaid. The two initial bidders to emerge were the Olivant group, led by former
Abbey boss Luqman Arnold, and the Virgin Group, headed by Sir Richard Branson. A little
later there was also a proposal from the existing managers of Northern Rock to rescue the
bank. Sadly for the government the financial value of the various bids was considered to
be simply too low. Selling out at the offered prices meant there was a risk that the busi-
ness might be bought out and re-structured and then sold on, giving one of the bidders
a substantial profit during the lifetime of the current government. This would have been
203
Article 37 Brown saw no other option
quite an embarrassment for the Prime Minister and his Chancellor if either of the prospec-
tive buyers had been able to make such a spectacular return on their investment. Imagine
the headlines in the press if the Virgin Group had pocketed a £1.5 bn profit ‘at the expense
of the poor old British taxpayer’. This could have done irrevocable damage to the Labour
government’s reputation.
So in the end the government’s advisers, Goldman Sachs, decided that ‘the private sale
option had run its course’ and on the 17 February 2008 the bank was nationalised, with
Ron Sandler confirmed as the new executive chairman. The clear losers in this whole busi-
ness were the shareholders of Northern Rock. In the wake of the announcement trading
in their shares was immediately suspended. It was left to an independent firm to assess
their monetary value on the day of the nationalisation. This resulted in the shareholders
taking legal action alleging that the government’s compensation scheme left the value of
the shares at virtually zero compared to the book value of Northern Rock before the
nationalisation which amounted to some £4 per share.
So should we feel sorry for the shareholders? In one sense it is hard to ignore the
massive financial loss that many of them suffered through no fault of their own. However,
if this outcome reinforced the reality that investment in shares is a risky business this could
be a useful warning for future investors.
204
Bank 2: Back in the USA, the government

acts to save Citigroup
As we have seen earlier in this Topic the credit crisis was firmly ‘born in the USA’ and in
this final article we examine the remarkable collapse of the US bank, Citigroup. If one bank
12
personified the excesses of the banking world in the heady days of 2006 it was Citigroup.

This was a bank that had built its ambitious growth model on a high-risk investment
strategy. It was one of the market leaders in the new markets of mortgage-backed securi-
ties and collaterised debt obligations. The bank’s senior managers seem to have
encouraged a culture that involved taking ever greater risks in order to grow the business
and to reap substantial financial rewards. Traders at Citigroup specialised in creating bil-
lions of dollars worth of the now infamous ‘mortgage-backed securities’. In the good times
this model worked, and the bank made billions of dollars from consumer borrowing (credit
cards), housing debt (mortgages), corporate borrowing (company loans), merger advice
(investment banking fees) and the activities of their investment banking teams (trading
profits). Sadly, there was insufficient attention paid to the key area of providing inde-
pendent risk management for all these activities.
In particular, nobody bothered to ask the key question: what happens if the economy
slows and house prices start to fall?
US government agrees to take biggest

single stake in Citigroup
Francesco Guerrera and Alan Beatte
The US government agreed to become the marks the first time the government has
biggest single shareholder in Citigroup had to take a big stake in a bank with this
yesterday, in the latest attempt to save the scale and geographical reach.
ailing financial group and to shore up the The government’s stake in Citi will
country’s banking system. bolster its depleted capital base but will
The partial nationalisation will give the also increase the authorities’ sway over
government a stake of up to 36 per cent in the company and Vikram Pandit, its chief
the troubled lender, capping a spectacular executive. Mr Pandit said the deal would
fall from grace for what was one of the not change Citi’s ‘strategy, operations or
world’s largest financial institutions. governance’. But the government has
At yesterday’s share price, the market already told Citi to revamp its board by
value of Citi – which has some $1600 bn appointing new independent directors
(£1117 bn) in assets and operations in 130 and is likely to further constrain its activi-
countries – was less than $9 bn. The latest ties in risky areas.
plan, the third time in four months that The rescue has been closely watched by
the authorities have had to rescue Citi, investors as a possible model for others.
205
Article 38 US government agrees to take biggest single stake in Citigroup
Under the plan, first reported by the The deal would result in a huge dilution
Financial Times last week, the Treasury for the bank’s common shareholders.
will not provide fresh funds but convert Shares were down 35 per cent at $1.58 in
up to $25 bn of its $45 bn-worth of pre- early afternoon in New York.
ferred stock into common equity at $3.25 Analysts said the structure of the deal
per share – a 30 per cent premium to made it virtually impossible for common
Citi’s closing price on Thursday. or preferred shareholders not to approve
Other preferred shareholders, it, as failure to convert the shares or ratify
including Government of Singapore the deal would end Citi’s life as a public
Investment Corporation and Saudi company.
Arabia’s Prince Alwaleed, will convert up
to $27.5 bn of their holdings at the same
price.
I The analysis
When the credit crisis appeared with a vengeance in the summer of 2007 the problems at
Citigroup quickly began to surface. By the early autumn the bank was forced to write off
$1.3 bn worth of sub-prime, mortgage-related assets. A slow death of Citigroup had
begun and its share price went into an almost permanent slide, reducing the company’s
stock market value from a high of nearly $240 bn to a little over $20 bn in just two years.
By the autumn of 2008 Citigroup was forced to go to the US government for urgent
financial assistance. After emergency talks with the US Treasury, the New York reserve bank
and Citigroup’s shareholders a rescue deal was put in place to head off a further sell-off of
their shares. In a further move the bank ran full-page adverts in newspapers to reassure
investors and customers that the bank would survive the crisis. The US government agreed
to provide emergency support by injecting $45 bn in return for taking preference shares
in the bank. These shares were far from free money for the bank as they agreed to pay a
5 per cent rate of dividend on them.
Despite this cash injection the problems at Citigroup remained severe and, as the FT article
included here shows, in early 2009 the US government was forced once again to step in to save
Citigroup. They feared that the bankruptcy of Citigroup could easily have risked the collapse of
the country’s entire banking system. There is little doubt that among the US authorities who
were firmly committed to the ‘free-market’ model there was a strong antipathy towards the
government taking an equity stake in any privately owned bank. This was the chief reason for
them allowing both Lehman Brothers and Bear Stearns to fail at an earlier stage in the credit
crisis. However, by the time that Citigroup was in serious trouble the US government had little
choice but to act. It was a case of step in and partly nationalise the bank or face the unthinkable
prospect of allowing it to go under as well. In the event Citigroup reached a deal which left the
US government owning 36 per cent of the struggling bank. This new rescue plan was built on
the earlier programme of assistance for the bank. It would see the conversion of up to $25 bn
of the preference shares into ordinary shares at a price of $3.25/share. The advantage to
Citigroup was that the dividend on these shares would only be a nominal amount. In addition,
it would now not have to pay the 5 per cent dividend on the remaining preference shares.
206
This swapping of preference shares for ordinary shares was also adopted by the other
holders of Citigroup shares including various sovereign wealth funds (SWFs) such as the
Government of Singapore Investment Corporation as well as such extremely wealthy
private investors as Saudi Arabia’s Prince Alwaleed Bin Talal. Before the banking crisis a
number of the SWFs had been viewed with deep suspicion. The concern had been that
their acquisition of large stakes in Western-owned companies might allow some countries 12
to extend their influence and possibly to use this power in a detrimental way. However,

when the banks ran out of cash, many larger governments across the world were forced
to put such concerns on the back burner in the desperate search for cash for their belea-
guered banks.
Against a background of the slightly more stable economic background that existed in
early June 2009 Citigroup were able to report their first quarterly net profits for almost two
years. The bank actually made a profit of some $1.6 bn compared to losses of over $5 bn
in the same period a year before. However, allowing for the dividend payments to pre-
ferred shareholders, this profit turned into a $1 bn loss. Despite this, the results were still
better than expected, resulting in a temporary bounce in the share price to $3.65 per
share. The damage suffered by its longstanding shareholders can be shown by comparing
this figure to the peak level of the share price which was close to $60/share in 2006 before
the credit crisis was born.
It should be clear from these examples from both sides of the Atlantic that, when the
banks got into trouble, the big losers were their shareholders and their many employees
who lost their jobs. We can but hope that the banks learnt lessons and that their mistakes
would not be repeated in the future.
I Key terms
Federal Reserve The Federal Reserve is the central bank of the United States. The key part of
the Fed is the Federal Open Market Committee (FOMC) that decides on changes in US mone-
tary policy. It is made up of 12 individuals. The core seven come from the Central Federal
Reserve Bank (based in Washington) and the other five represent the various Federal District
Reserve Banks. One of these, New York, has a permanent place on the FOMC. The other 11
banks share the remainder of the votes on a complex rotation system. The FOMC reviews the
outlook for the economy before deciding on the next move in interest rates.
Credit crunch This refers to the cost and availability of credit. It might be a government bor-
rowing (in the government bond market), a company borrowing (in the corporate bond
market), a house owner (with a mortgage) or a consumer (with a credit card). We have a ‘credit
crunch’ when the cost of borrowing is considered to be prohibitively expensive by historic stan-
dards or it is simply very difficult for more risky borrowers to obtain finance at all.

instrument.
Collateral This refers to any property or other assets that can be given as security on a loan. If the
borrower fails to make timely interest payments or return the principal, these assets can be seized.
207
FTSE 100 We start with the FTSE 100, which is the most is widely quoted UK stock market
index. It is based on the value of the 100 largest UK companies in terms of their market capi-
talisation. It started with a base level of 1000 in January 1984. This index is now quoted in real
time on the various news information systems that serve the city traders.
returns or try to make gains even in a falling market. The fund will rely on large amounts of bor-
rowing and will use derivative markets and short selling to achieve these aims.
FTSE Eurofirst (300) This is one of the FT’s more recently created stock market indices. It
attempts to track the performance of the leading European stock markets. It is shown on the
Front of the FT each day in the World Markets Data section.
Nikkei 225 This is the most closely followed index of Japanese share prices. The index is quite
broad as it is based on Japan’s top 225 blue-chip companies quoted on the Tokyo Stock
Exchange.
Dow Jones Industrial Average The DJIA is the main US stock market index. It is based on the
market movements of 30 of the largest blue-chip industrial companies that trade on the New
York Stock Exchange. The selection of these companies is revised regularly. It includes
companies like American Express, Boeing, Disney, General Electric, Honeywell, Intel, JP Morgan
Bank, Procter and Gamble.
Fed funds (effective) This is the most important short-term interest rate in the United States.
It refers to the overnight interbank lending that takes place in the United States money markets.
The money that one bank lends to another comes from any excess reserves held at the Fed. A
target level for the official Fed funds rate is set by the Federal Open Market Committee.
Repurchase market The term ‘repo’ is a shortened version of the term ‘repurchase’ agreement
that is used with this instrument. A commercial bank that is short of liquidity can obtain some
cash by selling high-quality financial market securities (normally bonds) to the central bank,
usually for a period of just 14 days. At the end of these 14 days the bank must repurchase the
securities from the central bank at the same price. However, it also has to pay an additional
amount which is determined by the current level of the repo rate.
Eurodollar deposits These are simply deposits of US dollars that are held outside the US.
Despite their name, Eurodollars do not have to be held in Europe.
Commercial paper This is a form of very short-term financing instrument used by companies.
The normal maturity of commercial paper is 270 days.
Interbank markets This refers to activities that take place in the money markets. There will be
some banks that have too much money and other banks with a lack of funds. This leads to a
very active interbank market where the banks borrow and lend short-term funds between them-
selves. The key financial market instrument traded here is the London Interbank Offered Rate
(Libor).
Sterling Libor or Euribor This is the rate used for loans made to low risk banks in the London
208
The Euribor rate is the equivalent interbank rate but now for borrowing and lending Euros in
the money markets.
ECB Council This is the key part of the European Central Bank system. It is made up of a
President of the ECB plus five other members who are responsible for the ECB’s day-to-day
activities including determining the daily money market operations.
12
Structured investment vehicle (SIVs) These are large programmes created by investment

banks who seek to take advantage of the differences that exist between the cost of borrowing
short-term funds and the cost of borrowing long-term funds. SIVs will typically raise their cash
in the short-term commercial paper markets and then invest the proceeds in much longer-dated
securities such as bonds and mortgage debt. SIVs came to prominence during the ‘sub-prime
crisis’ as many of them invested heavily in large amounts of collaterised debt obligations
(CDOs). These CDOs are packages of debt with various degrees of risk. Some CDOs invested
heavily in the sub-prime mortgage debt. As a result of the default of some of these mortgages
there are large numbers of CDOs that will be worth much less than they are currently perceived
to be. The investment banks that own the CDOs were forced to write off a significant part of
the value of these SIVs.
Bank of England The UK’s central bank. It was made independent from the UK government in
1997. Since then it has been in charge of setting short-term interest rates in the UK money
markets. The main official interest rate in the UK is called the ‘repo rate’. The target for this rate
is set by the Bank of England’s Monetary Policy Committee. At the time of the Northern Rock
crisis, the Bank of England’s Governor was Mervyn King.
Financial Services Authority This is an independent non-governmental body that has a key
role in regulating the performance of financial services institutions. It is made up of a FSA board
with a chairman, a chief executive officer, three managing directors and nine non-executive
directors. The FSA has its statutory powers granted under the Financial Services and Markets Act
of 2000. At the time of the Northern Rock crisis the FSA’s chief executive was Hector Sands, a
former investment banker at Union Bank of Switzerland (UBS).
The Treasury This is the part of the government that is in charge of official spending and
revenue decisions. In addition, it plays a key role in the regulation of the financial services
industry. The Treasury is overseen by the Chancellor of the Exchequer. At the time of the
Northern Rock crisis the Chancellor was Alistair Darling.
Lender of last resort The central bank has a key function in being the lender of last resort. This
means that if a bank has nowhere else to go to in order to get funds, it can always go to the
central bank to borrow some money to clear a cash imbalance. Without this faculty the banks
would be at risk of running out of cash and then facing a complete loss of confidence among
their depositors.
Retail deposits This refers to the bank deposits held by ordinary customers. In contrast, whole-
sale deposits are held by companies and other financial institutions.
Securitisation The process of breaking down a very large financial asset into smaller units that
can be sold to investors. A good example might be mortgage-backed securities where the mort-
gage debt is pooled together and then sold in smaller units.
209
Sovereign wealth funds (SWF) These are a form of investment vehicle used by countries to
build up financial assets with the funding coming largely from their reserves. The primary aim
of these funds is to make investments that will benefit the country’s economy and citizens over
the long term. The countries with a proliferation of SWFs will normally be those with significant
budget and trade surpluses which have allowed them to build up a pool of reserves that can
then be invested. In addition, the SWFs are also common among countries rich in raw materials
including the oil states.

1. Is it correct to blame the crisis at Northern Rock entirely on developments in the
international financial markets?
2. In the context of the US mortgage market explain the term ‘sub-prime’ lending.
3. Explain how complex financial instruments like CDOs and SIVs were a key part of the
‘credit-crisis’.
4. Why was Northern Rock unable to access funds from the repo market or the UK
money markets?
5. In what ways was the business model employed by Northern Rock very different
from that used by other UK banks?
6. To what extent did conflicts between the Treasury, the Financial Services Authority
and the Bank of England contribute to the failure to deal with crisis effectively in the
early days?
7. Discuss the long-term impact of the Northern Rock crisis on:
a. The UK government (especially the Treasury).
b. The Bank of England.
c. The UK’s reputation in international financial markets.
d. The UK banking system.
e. UK savers and borrowers.
8. It has been claimed that in bailing out Northern Rock the UK authorities ran the risk
of injecting moral hazard into the financial services industry. What is meant by this
term and do you agree that this is a serious risk?
9. ‘The biggest losers in the Northern Rock crisis were the shareholders. They saw a
sharp fall in the value of their shares and had a planned dividend cancelled on the
25 September 2007’. Do you agree with this statement?
10. Why did the UK government finally decide to nationalise Northern Rock?
11. Explain how the US government used ‘preferred stock’ in the rescue of Citigroup.
12. What are sovereign wealth funds? What role did they play in the bail-out of
Citigroup?
13. Explain how the swapping of preferred stock for common equity was used to alle-
viate the problems at Citigroup in early 2009.
210
Data section – this is normally about six pages in from the back page.
Find the section on Interest Rates (right-hand side of page – halfway down). Now go to
Market Rates. You will see: 12
US$Libor

EuroLibor
£ Libor, etc.
Focus only on £ Libor:
1. What is the overnight £ Libor rate?
2. What is the one-month £ Libor rate?
3. What is the three-month £ Libor rate?
4. What is the one-year £ Libor rate?
Using this information, describe the current state of the UK money markets. Are there any
signs of a continued premium rate for banks to borrow funds for three months plus?
I Go to the web
Go to the Bank of England website at www.bankofengland.co.uk.
Now go to the Markets Section (see top of page). Now go to Sterling Money Market
Operations Section (see sections on left-hand side).
You are required to explain fully the Bank of England’s ‘four specific objectives’ for their
operations in the sterling money markets. Make sure you do this in your own words.
I Research
Brummer, A. (2008) The Crunch: The Scandal of Northern Rock and the Escalating Credit Crisis,
London: Random House.
Turner, G. (2008) The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic
Crisis, London: Pluto Press.
Walters, B. (2008) The Fall of Northern Rock. An Insider’s Story of Britain’s Biggest Banking Disaster,
Petersfield, UK: Harriman House.
You can also learn a great deal about the role of the Treasury, central banks and the Financial
Services Authority from their official websites. They are all fantastic learning resources with a
great deal of material on their activities.
www.fsa.gov.uk
211
www.hm-treasury.gov.uk
It is also essential to read the Financial Times just after the major meetings of these official
bodies.

212
Z01_BOAK1818_02_SE_GLOSSARY.QXP:FINA_ 3/11/09 08:25 Page 213
Glossary
AAA-rated This is the highest credit-rating that a bond issue can receive. See BOND CREDIT
RATING for more details.
Activist hedge funds Activist hedge fund managers target companies that are seen to be
underperforming compared to their rivals. They will then build up a stake in the business and
use that power to demand significant changes in the way the business is being run. This might
include an attempt to oust the existing managers or close down loss-making activities. (page
188)
Activist shareholders Shareholders range from private investors with small stakes in the
business right up to the large financial institutions that often own a significant percentage of
the equity of a business. It is normally among these larger shareholders that we find the activist
shareholders. These are the shareholders who believe that the managers are not doing a good
job and as a result they will attempt to alter company policy and even possibly seek to replace
existing senior managers with new people who they think will do a better job. (page 12)
Annual general meeting (AGM) All public companies must invite their shareholders to an
AGM to vote on a number of important issues. This will include the approval of the annual
report and accounts, the re-election of the directors and the dividend level. This is the key forum
allowing the shareholders to express their views to the managers of the company. For example,
in recent years it has allowed some pressure groups to exert pressure on companies involved in
the arms industry or other so-called unethical sectors. (page 170)
Arbitrage This is a very common practice among financial market traders. They will simul-
taneously sell (or buy) a financial instrument (for example a share or a bond) and at the same
time take an equal and opposite position in a similar instrument. This transaction will give them
a financial profit. An arbitrage is possible where there is a clear price anomaly that has been
identified between the markets involved. In theory such arbitrage trading is considered risk free.
This makes it particularly attractive. (page 73)
Auctions (bonds) Most new government bond issues are sold through a system of auc-
tions. Normally the country’s Treasury is in charge of new issues. They will give an early
warning of the maturity of the issue. And then a week or so before it will firm up details of
the size of the issue, the total amount being raised, the maturity and the bond’s annual
coupon. (page 65)
Bank of England The UK’s central bank. It was made independent from the UK government
in 1997. Since then it has been in charge of setting short-term interest rates in the UK money
markets. The main official interest rate in the UK is called the repo rate. The target for this rate
is set by the Bank of England’s Monetary Policy Committee. (page 209)
213
Glossary
Banks analyst This is the person employed at an investment bank whose job it is to advise
the bank’s clients on the major financial institutions operating within the financial services
industry. The analyst will be required to value these businesses and offer comparisons between
his/her own and the market’s valuations as reflected in the current share prices. (page 77)
Benchmark 10-year Treasury note The United States has the world’s largest government
bond market. The Treasury market is backed by the US government and, as a result, is seen as
having no default risk. It sets the standard for all other dollar-denominated bonds. As a result,
other dollar issues will see their yields set in relation to the equivalent US Treasury issue.
(pages 29, 52)
Benign credit conditions See CREDIT CONDITIONS
Bond A bond is a security issued by a government or a corporation which represents a debt

that must be repaid normally at a set date in the future. Most bonds pay a set interest rate each
year called the bond’s coupon. The other key characteristic of a bond is its maturity. This is the
date that the bond will be redeemed. (page 76)
Bond auction process See AUCTION (bonds)
Bond credit rating New bond issuers are normally assigned credit ratings by the various
companies that are involved in this activity. They include Standard and Poor’s and Moody’s. The
highest credit rating allocated by Moody’s is a AAA. For example, this is awarded to the German
government’s bond issues. (pages 66, 82)
Bond yields See YIELDS
Bond yield spreads This refers to the yield on a particular bond issue minus the yield on the nearest
comparable government bond issue. The spread is determined by a combination of the bond’s credit
rating, liquidity and the market’s perception of its risk relative to the other bond. (page 66)
Book runner This is the lead manager who is in charge of the whole process in a new bond
issue. They will be jointly responsible with the issuer for inviting other banks to work on the new
issue in activities such as syndication and underwriting. (page 73)
Break-even A company achieves break-even when its sales revenue equals total costs. These
costs will include some fixed costs as well as the variable costs that will be dependent on the
level of sales. (page 96)
Brokerage commissions If you wish to use the services of a stockbroker in order to buy or
sell shares, you must pay the broker’s fees. This ‘brokerage commission’ is normally a set per-
centage of the total transaction or some kind of flat-rate charge. (page 129)
Budget deficit A country’s budget deficit refers to the difference between its spending and its
revenue. It is normal for any government to spend more money on health services, education,
defence etc. than it can raise revenue from income taxes, sales taxes, etc. The result is a fiscal
deficit or a budget deficit. We normally like to compare a country’s budget deficit by expressing
it as a percentage of the country’s gross domestic product or income. (page 66)
Bulldog bonds These are sterling-denominated bonds issued by a foreign borrower in the UK
domestic market. (page 76)
214
Glossary
Bunds These are simply German government bonds. These are used to fund the difference
between federal government spending and revenue. As normal, the benchmark long-term gov-
ernment bond is the 10-year maturity. (pages 58, 83)
Business risk This refers to the general risk that can impact on a company’s cash flow or prof-
itability. It could be caused by general economic conditions (consumer spending, level of
interest rates, etc.) as well as more specific company factors (changes in key staff, strike action
by employees, etc.). (page 96)
Capital calls This can be defined as any additional money that equity holders will be required
to provide to meet a company’s financial deficit. (page 144)
Capital expenditure This is where a company spends money on various types of fixed assets
such as property and plant and equipment. These assets cannot easily be turned into cash and
are generally viewed as long-term investments. (pages 17, 154)
Capital structure This refers to the long-term finance that a business needs in order to trade.
This is made up of debt and equity finance. The debt finance will normally be in the form of a
bond that carries fixed interest payments and a set date when it will be redeemed. In contrast,
there are no guarantees of any financial returns to the providers of equity (the shareholders). If
a company does well and is highly profitable it is likely that there will be significant dividends
paid to the shareholders. However, if the company runs into financial difficulties, the dividends
will be cut back and they might disappear altogether. It should be clear that in terms of capital
structure the shareholders take a greater risk than the debt holders. As a result, it is reasonable
for the shareholders to expect a higher level of financial returns to compensate for this higher
risk. (page 92)
CBI surveys The Confederation of British Industry (CBI) is widely described as the employers’
organisation. It is voluntary group made up of around 1500 UK-based manufacturing
companies. It carries out a wide range of surveys to gauge its members’ views on the current
state of economic activity. It provides a useful overview of the state of manufacturing industry.
The surveys are sent out at the end of each quarter and the results are published about three
weeks later. (page 181)
Chief executive officer (CEO) This is the top person in the company who will have the main
responsibility for implementing the policies of the board of directors on a daily basis. Put simply,
he or she runs the business. (page 12)
Collateral This refers to any property or other assets that can be given as security on a loan.
If the borrower fails to make timely interest payments or return the principal these assets can
be seized. (page 207)
Commercial paper This is a form of very short-term financing instrument used by

companies. The normal maturity of commercial paper is 270 days. (pages 62, 208)
Companies’ cost of capital This refers to the financial return that is expected by an investor
in a company’s debt or equity issues. The cost of capital is seen as the annual percentage return
that an investor would expect if they were buying shares or bonds issued by a company. (page
101).
215
Glossary
Convergence This refers to the process that took place in the late 1990s whereby all the
prospective eurozone countries saw their government bond yields fall to the level of the lowest
yield that existed at this time. The view was that if the bonds were now issued in the same cur-
rency they should enjoy the same level of risk and therefore identical yields. (page 82)
Conversion premium This term refers to the difference between the current market share
price and the set conversion price. You will normally see this expressed as a percentage of the
current market share price. (page 56)
Conversion price It is the price that has to be paid per share when the bond holder decides
to convert their bond into shares. (page 56)
Conversion ratio This is the number of shares that a convertible bond can be converted into.
For example, if the conversion ratio is set at 40 then an investor will be able to convert every
£100 nominal value of the bond issue into 40 shares in the issuing company. (page 56)
Conversion value of the bond This is the value of a convertible bond if it were converted
into shares at the current market share price. (page 56)
Convertible bond These are bonds which provide the holders with the right to convert their
bonds into shares in the issuing company. This conversion option will be at an agreed price at a
set date in the future. Initially this will not be a worthwhile transaction as the conversion share
price will be set well above the current market share price. However, as the market share price
rises in value over time so the conversion will soon be a valuable option for the bond holder.
(pages 62, 73, 92)
Corporate brokers These are important financial institutions that will make a market in a
company’s shares. This means that they must be willing to quote both buy and sell prices,
enabling investors to deal in the shares. They could also act as an adviser to a company that
was organising a new share issue. (page 101).
Corporate governance This is a general term used to describe the relationship between the
owners of a business (the shareholders) and the managers of the business. It covers the various
mechanisms by which the shareholders can try to make sure that the managers act in their
interest. This should ensure that the managers are open, fair and fully accountable for all their
actions. (page 7)
Coupon This is the interest rate that is set for a bond when it is first issued. In practice, the
coupon is normally paid in two equal instalments. (page 72)
Credit conditions This simply refers to the cost of borrowing money. It might be a govern-
ment borrowing (in the government bond market), a company borrowing (in the corporate
bond market), a house owner (with a mortgage) or a consumer (with a credit card). We have
‘benign credit conditions’ when the cost of borrowing is considered to be low by historical stan-
dards. We have ‘tight credit conditions’ when the cost of borrowing is considered to be high
by historical standards. (page 57)
Credit crunch This refers to the cost and availability of credit. It might be a government bor-
rowing (in the government bond market), a company borrowing (in the corporate bond
market), a house owner (with a mortgage) or a consumer (with a credit card). We have a ‘credit
216
Glossary
crunch’ when the cost of borrowing is considered to be prohibitively expensive by historical

standards or it is simply very difficult for more risky borrowers to obtain finance at all. (page 207)
Credit default swaps (CDS) This is a financial market instrument that is designed to offer a
bond investor complete protection against the risk of default. Essentially, the seller of the swap
takes over the risk of default on the bond issuer for a one-off payment. In the event of any
default the seller of the swap will be fully liable to pay the par value of the bond and any due
interest payments to the credit swap buyer. (page 83)
Credit risk premium This is the higher return that a bond investor will require to compen-
sate for the possible financial loss due to the bond issuer being unable to make timely payments
of interest or the principal. (page 83)
Currency risk See ECONOMIC RISK, TRANSACTION RISK and TRANSLATION RISK.
DAX index The DAX index is the most important German stock market index. It is considered
to be the standard benchmark for shares quoted on the Frankfurt Stock Exchange. It started in
1984 with an initial value of 1000. This is referred to as the Xetra DAX index on the front of the
Financial Times in the World Markets data. (page 57)
Debt capital See CAPITAL STRUCTURE.
Debenture This is the most secure form of bond issue that a company can offer. The holder
of the bond will be entitled to receive various assets owned by the company if there is any
default on the terms of the issue.
Default This where a borrower takes out a loan but fails to keep to the original agreed
schedule of interest payments and final capital repayments. A bond issued by the governments
of the United States or United Kingdom is generally regarded to be free of default risk. In con-
trast a bond issued by a company might well have significant risk of default. For example, a
company might not be able to keep up with the interest payments on the loan as a result of a
downturn in its profitability. (pages 13, 38)
Delisting This is simply when a company is removed from a stock exchange. This might be
done by a company that decides that it has simply become too onerous to meet all the rules
and regulations set out by the stock exchange. Such companies are not necessarily bankrupt
and it is quite possible that the shares will still trade in the over-the-counter-market where
buyers and sellers will be brought together. (page 7)
Diluted (shareholdings) This is when a company issues additional share capital resulting in
existing shareholders seeing a diminished value in terms of their voting power and their value.
(page 102)
Discounted cash flow valuation Put very simply, this is where we take the future cash flows
which will be earned by a company and multiply them by an appropriate discount factor to get
their present value. This is a widely used technique to place a value on the share price of a par-
ticular company. (page 116)
Dividends A normal dividend is simply the payment made each year to all shareholders in the
company. The exact level is set by the company’s board of directors. This payment will be made
to all shareholders who are registered on a particular date. In most cases these dividends are
paid in cash. (page 156)
217
Glossary
Domestic bond This is where the issuer launches a bond in its local currency and home country.
For example, a UK company might launch a new £500 m bond issue in London. (page 61)
Dovish See HAWKISH.
Dow Jones Industrial Average (DJIA) The DJIA is the main US stock market index. It is
based on the market movements of 30 of the largest blue-chip industrial companies that trade
on the New York Stock Exchange. The selection of these companies is revised regularly. It
includes companies like American Express, Boeing, Disney, General Electric, Honeywell, Intel, JP
Morgan Bank, Procter and Gamble. (pages 52, 208)
ECB Council This is the key part of the European Central Bank system. It is made up of a
President of the ECB plus five other members. They are responsible for the ECB’s day-to-day
activities including determining the daily money market operations. (page 209)
Economic risk Type of currency risk that is caused by exchange rate movements impacting
on the competitiveness of a company. Put simply, if a company’s home currency appreciates,
this will make the company less competitive as its goods and services become more expensive
in overseas markets. It is normal to see economic risk described as being a much more general
risk than either transaction or translation risk. (page 181)
Efficient market This refers to the way that share prices react to new information. A stock
market is efficient if it reacts quickly and accurately to a new market-sensitive announcement.
So if a company announces a surprise increase in dividends, its share price should rise immedi-
ately. If instead it reacts very slowly or indeed even falls in price, the market will be highly
inefficient. (pages 81, 116)
Emerging markets This refers to the financial markets of developing nations. In general,
these markets have not been trading for long and as a result they are seen as being more risky
than traditional financial markets. (page 116)
Equity capital See CAPITAL STRUCTURE.
Equity fund-raising This simply refers to the company raising additional finance through the
issue of extra share capital. (page 102)
Euribor This is the interbank rate that applies to all short-loans money market made in the
euro. The rate that applies to these loans will generally be close to the European Central Bank’s
repo rate.
Eurobond This is where the issue takes place outside of the country of the currency that the
bond is denominated in. For example, a German company might launch a new $500 m bond
issue in France. This type of bond is called a Eurobond because the issue is in US dollars and it
takes place outside of the United States. You should be aware the term Eurobond does not
mean that the issue has to take place within the European financial markets. (page 61)
Eurodollar deposits These are simply deposits of US dollars that are held outside of the US.
Despite their name Eurodollars do not have to held in Europe. (page 208)
European Central Bank (ECB) This is the eurozone’s central bank. It sets the level of short-
term interest rates for all the countries that have adopted the euro. The main policy objective
218
Glossary
of the ECB is to maintain price stability in the medium term. This is defined as a 0–2 per cent
target range for consumer price inflation. The key part of the ECB is the Governing Council that
meets every fortnight on a Thursday. (page 58)
Eurozone The countries that use the euro as their common currency. (page 82)
Exchange Rate Mechanism (ERM) In the days before the existence of a single European
currency, there was a very complex system set up to control exchange rate fluctuations between
participating currencies. For a very brief time the UK became part of this system and this caused
severe problems for the UK economy which was then in recession. The government had to keep
interest rates very high in the middle of this downturn in a vain attempt to defend the pound’s
value. This policy came to a dramatic end on Black Wednesday in September 1992. The pound
crashed out of the ERM and interest rates fell sharply. (page 180)
Exotic products This is a term to cover new innovative financial markets products. The use
of the terw ‘exotic’ denotes that these are different from the normal version of this product. You
will see it used in several contexts such as exotic bonds, exotic swaps, exotic options. (page 73)
Federal Reserve (and the Federal Open Market Committee) The Federal Reserve is the
central bank of the United States. The key part of the Fed is the Federal Open Market
Committee (FOMC) that decides on changes in US monetary policy. It is made up of 12 indi-
viduals. The core seven come from the Central Federal Reserve Bank (based in Washington) and
the other five represent the various Federal District Reserve Banks. One of these, New York, has
a permanent place on the FOMC. The other eleven banks share the remainder of the votes on
a complex rotation system. The FOMC reviews the outlook for the economy before deciding on
the next move in interest rates. (pages 27, 207)
Fed funds rate (effective) This is the most important short-term interest rate in the United States.
It refers to the overnight interbank lending that takes places in the United States money markets.
The money that one bank lends to another comes from any excess reserves held at the Fed. A target
level for the official Fed funds rate is set by the Federal Open Market Committee. (pages 26, 208)
Fed watching This refers to the various economists who spend their time studying every
market movement or speech from a key official of the Federal Reserve Bank in order to try to
predict the next move in US interest rates. Getting these predictions right is worth a great deal
to the large investment banks as their traders can use these forecasts to make massive profits in
their bond, share and money market trading operations. (page 26)
Financial Services Authority (FSA) This is an independent non-governmental body that

has a key role in regulating the performance of financial services institutions. It is made up of
an FSA Board with a chairman, a chief executive officer, three managing directors and nine non-
executive directors. The FSA has its statutory powers granted under the Financial Services and
Markets Act 2000. (page 209)
Flat yield curve A flat yield curve shows the level of yields being broadly similar across the
maturity spectrum. (pages 27, 65)
Foreign bond This is where an issuer goes to another country to issue a bond in a foreign cur-
rency. For example, a German company might launch a new $500 m bond issue in the United
States. This type of foreign bond issue is called a Yankee bond. (page 61)
219
Glossary
FTSE Eurofirst (300) This is one of the FT’s more recently created stock market Indices. It
attempts to track the performance of the leading European stock markets. It is shown on the
front of the FT each day in the World Markets data section. (page 208)
FTSE indices We start with the FTSE-100 index which is the most widely quoted UK stock
market index. It is based on the value of the 100 largest UK companies in terms of their market
capitalisation. It started with a base level of 1000 in January 1984. This index is now quoted in
real time on the various news information systems that serve the City traders. Next we have the
FTSE-250 index which is simply an index of the next 250 companies in terms of their market
capitalisation. Next we have the FTSE-350 index which simply combines the FTSE-100 and the
FTSE-250 indices. Lastly, there is the FTSE All-Share UK index, which, as the title suggests, is the
broadest of the UK stock market indices. It covers over 800 companies which together account
for about 98 per cent of the total market capitalisation. (pages 144, 181, 208)
Fund managers The fund manager’s main role is to build a successful investment strategy
enabling them to optimise the value of the investment portfolio. He or she will have to monitor
financial markets and constantly assess market risks. In addition, the fund manager will have to
communicate their objectives to their clients. (page 188)
Futures markets In the money markets there is a well established futures market that allows
banks to deal at a set interest rate for a transaction on a specified future date. For example, a
bank could arrange to lend £10 m to another bank at a set interest rate on a specific date in the
future. The attraction of this deal is that both parties know now what the interest rate is going
to be. There is no uncertainty as this transaction will not be affected by any subsequent rise or
fall in money market interest rates. (pages 43, 83)
Gainsay This means to deny or contradict something or somebody. In this context the FT
article suggests that the need to get shareholder approval for a new share issue prevents
companies from acting against the interests of their shareholders by going to ‘more manage-
ment-friendly’ investors to fund a new share issue. (page 102)
Gearing This refers to the proportion of debt in the company’s capital structure. A company is
termed highly geared if it has a large amount of debt finance and only a small amount of equity
finance. In contrast, a low geared company will be largely financed by equity finance. (page 96)
German DAX index See DAX INDEX.
Global credit crisis This refers to the crisis that affected financial markets in the summer of
2007, which stemmed from the subprime crisis that started in the US. As a result, banks became
very reluctant to lend to each other and the interbank markets saw their liquidity dry up. (page
82)
Government debt These are bonds issued by governments to fund the difference between
their spending and revenue. (page 82)
Greenmailer This refers to a very unusual situation in corporate takeover bids. It is where one
company (the takeover company) deliberately builds up a large stake in another business (the
target company) and then appears to launch an unfriendly takeover. This whole process is
designed to force the target company to repurchase the stock at a substantial premium to
prevent a takeover bid. (page 170)
220
Glossary
Growth capital deals This refers to the provision of finance to those companies that seem to
offer the prospect of particularly high rates of growth. This might be because of the type of
service or goods that they provide. For example, a high-technology company might be viewed
as being higher growth than a utility like an electricity supplier. (page 144)
Growth strategy This refers to the strategy employed by a company aimed at increasing its
market share. It is possible that in the short term a company might set out to chase additional
sales even at the cost of reducing short-term earnings. (page 17)
Growth/mature company A growth company is one that has a rate of growth that is signifi-
cantly higher than is the norm. They will generally be characterised by heavy investment
programmes and low dividend payments to their shareholders. In contrast, a mature company
has already done its growing and it has now reached the stage where future expansion plans
are limited by the size of their market. These companies will be characterised by much less
ambitious business investments but rather more generous dividend payments to shareholders.
Group of seven This refers to some of the most influential economies in the world including the
United States, Germany, Japan, France, UK, Canada and Italy. They meet regularly to discuss econ-
omic policy. These days their meetings often involve Russia (so it is really a G-8 now). (page 44)
Hawkish (and dovish) In the context of central banks, commentators often use the terms
hawkish and dovish to describe members of the central bank committees that set interest rates.
For example, a hawkish member of the FOMC tends to be very concerned about maintaining
a clear anti-inflation policy and so is more likely to vote for an increase in interest rates. In con-
trast, a dovish member of the FOMC tends to be more relaxed about the inflation outlook and
as a consequence is less likely to vote for any increase in interest rates. (page 30)
Hedge fund This refers to a particular type of investment management where the fund
manager will employ a range of different investment tools in an attempt to maximise the returns
or try to make gains even in a falling market. The fund will rely on large amounts of borrowing
and will use derivative markets and short selling to achieve these aims. (pages 38, 73, 131, 143,
188)
Hedging This term is widely used in financial markets to indicate that an investment in a
financial market product is being made to minimise the risk of any unfavourable movement in
the price of a particular financial asset. In the context of the foreign exchange market, hedging
refers to the process of a company attempting to protect itself against an adverse movement in
the foreign exchange market. The most commonly used hedging technique in this context is
the forward foreign exchange market. (page 181)
Infrastructure This is defined as investment projects that will focus on a nation’s basic
network of assets such as roads, railways, communications systems, etc. (page 144)
Initial public offer (IPO) An IPO refers to the situation where a company first sells its shares by
listing on the stock exchange. This gives it a much wider access to increase its shareholder base.
In addition, it provides much great liquidity in terms of the trading of the shares in the company.
Companies considering a new IPO will appoint an investment bank to manage the process. They
will meet the company and be heavily involved in valuing the shares, preparing a prospectus and
getting investors interested in the new issue. The investment bank will be very well rewarded for
this work with substantial fees often being paid to ensure a successful IPO. (pages 38, 111)
221
Glossary
Institutional investors These are the large pension funds and insurance companies that are
the key investors in financial markets. They look to invest in long-term assets to match their
long-term liabilities (paying out pensions). These investors have flourished in recent years due
to the greater wealth of the private sector. In contrast, the private clients refer to the individuals
who invest on their own behalf. (page 112)
Interbank markets This refers to activities that take place in the money markets. There will
be some banks that have too much money and other banks with a lack of funds. This leads to
a very active interbank market where the banks borrow and lend short-term funds between
themselves. The key financial market instrument traded here is the London Interbank Offered
Rate (Libor). (page 208)
Intermediaries These are financial institutions that act as a middleman between those cash
surplus units in the economy (the lenders) and the cash deficit units in the economy (the bor-
rowers). Put simply, they enable people with money to meet people who need money. (page
129)
Internal rate of return The internal rate of return (IRR) is a widely used method for
companies to decide if a new business investment is worthwhile in financial terms. The IRR of
a project is the discount rate that equates the present value of the expected future cash outlays
with the present value of the expected cash inflows. As a result, the project’s net present value
is zero. (page 139)
Investment banks An investment bank acts as an intermediary between the issuers of

capital (governments and companies) and the investors in capital (pension funds and insur-
ance companies). The staff employed in an investment bank will work either in the
investment banking division (IBD) which deals with the new issues of debt and equity capital
or the markets division which deals with the investors in new bond and equity deals. (pages
37, 101)
Investor protection This refers to the defence of shareholders’ rights including in this case
the first opportunity to buy any new shares issued by the company. (page 102)
Investor relations A key aspect of good corporate governance is the requirement that the
senior managers of a company are expected to keep a constant dialogue with the shareholders.
This includes the necessity to make sure they are in touch with their opinions on a range of
important issues. This should be done through such things as the annual general meeting, the
sending of regular news updates and the provision of a company website. Most of these web-
sites now include a section covering investor relations. (page 7)
Japanese government bonds (JGBs) This is the world’s second largest government bond
market. There has been a massive increase in the size of the JGB market in recent years. This is
due to a long-standing recession that has led to the government’s efforts to boost economic
growth through massive tax cuts and large government spending increases. (page 76)
Leases See SALE AND LEASE BACK.
Lender of last resort The central bank has a key function in being the lender of last resort.
This means that if a bank has no where else to go to in order to get funds it can always go the
central bank to borrow some money to clear a cash imbalance. Without this faculty the banks
222
Glossary
would be at risk of running out of cash and then facing a complete loss of confidence from their
depositors. (page 209)
Leveraged This refers to the capital structure of the new company being formed. The term
leveraged suggests that the company will be financed largely by borrowed money. (page 139)
Leveraged buyout This term is used in the context of management buyouts and it suggests
that the new company will be financed largely with debt capital. (page 139)
Liquid yield option notes (lyons) These are zero-coupon bonds that are issued below their
par value. This guarantees the holder a return despite the zero coupon. (page 74)
Liquidity In financial markets this normally refers to how easily an asset can be converted into
cash. Therefore, notes and coins are the most liquid financial asset. In general, the more liquid
an asset, the lower is its return. (page 65)
Liquidity premium This term refers to how easily an asset can be converted into cash (notes
and coins). In general, the more liquid an asset, the lower is its return. Investors will pay a higher
price in order to secure a liquid financial asset. This is what is known as the liquidity premium.
(page 83)
List This refers to the companies whose shares are quoted on the Main List of the UK
Exchange. Companies who want to be listed must meet the very exacting criteria which are
contained in the Stock Exchange’s ‘Yellow Book’. These criteria include the amount of shares
that have to be in the public’s hands ahead of trading in the shares, the company’s trading and
financial history and the suitability of the board of directors. (page 111)
London Interbank Offered Rate (Libor) This is the rate used for loans made to low-risk
banks in the London money markets. You can get a Libor rate for a wide range of money market
maturities. It starts with overnight money and then goes to one month, three months, six
months and one year. (page 43)
London Stock Exchange (LSE) This is the main stock exchange in the UK where companies
raise new equity finance through their initial public offer (IPO) and subsequent share issues
(rights issues). (page 102)
Long-term finance In most companies this is the key finance that underpins business activi-
ties. It is made up of a combination of equity finance (provided by the shareholders) and debt
finance normally issued in the form of new bond issues. This long-term finance will allow the
company to make new investments and it could also fund mergers and acquisitions. (page 12)
Margins This is the difference between the company’s average selling price for its goods or
services and the costs that are required to produce them. (page 116)
Market buyouts This term is normally associated with the provision of finance to help the existing
managers of a business take control of their company. The private equity firm will help them fund
the buyout in the hope of generating a significant return for their shareholders. (page 144)
Market capitalisation This gives the current overall stock market value of the company. It can
be easily calculated by multiplying the numbers of shares in issue by their current market share
price. In some cases companies will have more than one class of shares. In this case it is necessary
to add together the different classes of shares to get the total value of the company. (page 156)
223
Glossary
Matilda bonds Australian dollar-denominated bonds issued by a foreign borrower in the

Australian domestic market. (page 76)
Mergers This is where two companies decide that it would be to their joint benefit to come
together to form a new business entity. With a merger the process is normally friendly with the
full consent of both sets of shareholders. (page 165)
Monetary Policy Committee The Bank of England’s Monetary Policy Committee (MPC) is in
charge of setting UK interest rates. It is made up of nine members: the Governor of the Bank of
England, two Deputy-Governors, two Bank of England Executive Directors and four independent
members. The MPC is required by the government to ensure that the UK economy enjoys price
stability. This is defined by the government’s set inflation target of 2 per cent. (page 42)
Monetary policy When you see the term monetary policy in the context of central banks it
refers to interest rate policy. A central bank tightens monetary policy when it raises interest
rates. (page 30)
Money laundering Money laundering is the process of trying to conceal the source of funds
generated by some illegal activity. This money might have come from a range of activities
including drug smuggling, illegal gambling, etc. The aim of the operation is to make it seem as
though the money that has been illegally earned actually comes from a perfectly legal activity.
Monopolies and Mergers Commission The Competition Commission actually took the
place of the Monopolies and Mergers Commission in 1999. In simple terms, the MMC had the
task of ensuring that the market in the provision of various goods and services remains com-
petitive. (page 102)

instrument. (pages 38, 207)
NASDAQ composite This is a rival stock market exchange based in the United States. It is run
by the National Association of Securities Dealers and its automated quotation system gives us
the NASDAQ index, which began in 1971 with a value of 100. It now includes nearly 5000
companies with each one assigned to one of the eight sub-indices – Banks, Biotechnology,
Computer, Industrial, Insurance, Other Finance, Telecom and Transportation. In general, the
NASDAQ index is seen to focus on newer and emerging companies. (page 52)
Nikkei 225 index This is the most closely followed index of Japanese share prices. The index
is quite broad as it is based on Japan’s top 225 blue-chip companies quoted on the Tokyo Stock
Exchange. (page 208)
Nominal share price This is merely a value given to a company’s share which is only used for
accounting purposes. Unlike the par value of a bond it has no direct link to the market price. (pages
120, 129)
Nonagenarian This refers to a person who is aged between 90 and 99 years old. (page 129)
Non-executive chairman and non-executive director (NED) This is supposed to be a

person who is independent of the core management team. He or she will normally be employed
on a part-time basis and will chair the main board of directors. In addition, the CEO can look
224
Glossary
to the non-executive chairman for advice and guidance. You will also see the term NED, which
stands for non-executive director. Most public companies will employ a number of part-time
NEDs to give independent advice on the running of the company’s operations. (pages 13, 17)
Non-voting preference shares In many ways, preference shares can be seen to be very similar
to bond finance. They normally pay dividends at a set percentage very much like the coupon on
a bond issue. And, in addition, they will normally have a set redemption date. However, unlike
bonds, the dividends on a preference share are paid at the discretion of the board of directors of
a company. Most preference shares are non-voting which means that the holders will not have
the right to vote on corporate policy at the annual general meeting. (page 92)
Pension fund deficit This refers to the crisis that affected companies in the wake of the
financial market weakness of 2008, which led to many companies having inadequate financial
provision in order to cover the liabilities to their employees in terms of future pension payments.
(page 120)
Plain vanilla This denotes the simplest version of any type of financial market instrument. It
alludes to ice cream varieties. A plain vanilla ice cream is the simplest type you can buy. It has
no chocolate flake or any sauces! (page 74)
Poison pill When a company is subject to an unwanted takeover bid there a number of
measures that it can take to try to defend itself. One such technique is called a poison pill.
This is where a company introduces some measure that will seriously damage the interests
of the company making the takeover bid. This might, for example, be an issue of a new
bond which following a takeover bid would give the bond holders the option to redeem
their bond immediately at a significant premium to its par value. This will act to deter any
bidder. (page 170)
Pre-emption rights This refers to one of the very longstanding principles of corporate law. It
gives all shareholders the first right to buy any additional shares being sold by companies. The
new shares would be offered to existing holders in direct proportion to their existing holdings.
So that if you owned 10 per cent of the existing shares in a company you would be given the
right to buy 10 per cent of the new shares being sold via a rights issue. These additional shares
are normally sold at a significant discount to the existing market share price to ensure a suc-
cessful completion of the transaction. (page 101)
Price–earnings ratio The PE ratio is calculated by taking the market share price and dividing
it by company’s earnings per share. This ratio is often used to compare the current stock market
value of a company. (pages 112, 157)
Primary and secondary markets The IBD will work with companies with their initial issue
of new shares. This is called the primary market. The markets division will then work in the sec-
ondary market, which is where new buyers can purchase these shares from existing holders.
This is normally a standard marketplace like the stock exchange’s official list. (page 38)
Private banking This refers to banks that manage the financial affairs for ‘high net worth’
individuals. (page 77)
225
Glossary
the stock market as soon as possible. Once they are removed from a quoted stock market, the
private equity firms can then set about making a series of significant changes designed to
increase their ultimate market value. The term private equity is also used also to cover other
areas such as venture capital where new start-up businesses receive finance in their early stages
of development. Strictly speaking, private equity is different from venture capital as the deal size
tends to be much larger and the investment is in more established companies. (pages 115, 139,
143)
Profits warning Companies are required to keep shareholders well informed in terms of the
performance of the company. As a result, if a company knows that its future profits will be sig-
nificantly less than the stock market currently believes, it is required to warn the market. The
result of such a warning is normally a sharp fall in the share price. (page 7)
Property assets Accountants like to distinguish between current assets (these are very short term
and will last less than a year) and fixed assets (longer term and will last more than a year). For
example, the key fixed asset for a company such as a large supermarket chain will be its vast prop-
erty portfolio. This will include many high street stores as well as distribution warehouses. (page 115)
Proprietary trading This is where the investment bank uses its own capital to fund trading
strategies that are designed to earn them significant profits. (page 38)
Real estate group This is a key division within an investment bank that deals with any aspects
of commercial property deals. (page 38)
Redeemable ‘B’ shares This refers to a type of share capital which has reduced or zero
voting rights. These shares are generally redeemable which means that they have a fixed life,
unlike most ordinary shares which have an infinite life. In recent years a number of companies
have given their shareholders redeemable ‘B’ shares instead of cash dividends. (page 154)
Repurchase rate (repo rate) The term repo is a shortened version of the term ‘repurchase’
agreement that is used with this instrument. A commercial bank that is short of liquidity can
obtain some cash by selling high quality financial market securities (normally bonds) to the
central bank usually for a period of just 14 days. At the end of these 14 days the bank must
repurchase the securities from the central bank at the same price. However, it also has to pay an
additional amount which is determined by the current level of the repo rate. (pages 42, 208)
Retail deposits This refers to the bank deposits held by ordinary customers. In contrast,
wholesale deposits are held by companies and other financial institutions. (page 209)
Retail Price Index/Consumer Price Index Until 2003, the UK government’s target for
inflation was set in terms of the percentage annual increase in the average prices of goods and
services as measured by the Retail Price Index (RPI). There was some controversy in 2003 when
the relevant inflation measure was changed to the Consumer Price Index (CPI), which excludes
certain important costs such as council tax and mortgage interest payments. (page 43)
Rights issue This is where a company issues some additional shares on a pro rata basis to
existing shareholders. The new shares are normally sold at a discount to the current market
price. These issues provide no access to new shareholders. Normal rights issues are popular
because they can be made at the discretion of the board of directors. The shareholders like the
discounts available and they leave the balance of voting rights unchanged. (page 170)
226
Glossary
Risk aversion Most rational people will always prefer to buy investments that carry the lowest
possible risk. So, if faced with the choice of a perfectly safe government bond (AAA–rated) or a
bond issue from another country with a poor credit history, the rational person will always select
the low-risk option. (page 84)
Risk premium This is simply the extra financial reward that will be required to convince an
investor to hold an asset that has a risk of returning a capital sum that is less than the original
amount paid for it. (page 83)
Rival bid This is where there is a corporate takeover in progress and a new bidder emerges to
challenge the current company that is looking to buy a business. (page 120)
Sale and lease back This is a very common transaction used by companies that want to
extract the value of any significant assets. A company can sell its property and then lease it right
back from the buyer (normally a financial institution) in the same transaction. This enables the
owner to get the cash from the sale but at the same time the owner can still use the property
to carry out its business. The financial institution that buys the property is guaranteed a long-
term income from the lease on the property. (pages 116, 120)
Samurai bonds Yen-denominated bonds issued by a foreign borrower in the domestic

Japanese market. (page 76)
Securitisation The process of breaking down a very large financial asset into smaller units that
can be sold to investors. A good example might be mortgage-backed securities where the mort-
gage debt is pooled together and then sold in smaller units. (page 209)
Secured and unsecured debt Companies will normally have a range of different types of
debt capital. The lowest risk form of debt capital will be secured debt. This means that the debt
is secured on various assets owned by the business including property or plant and machinery.
If the business goes into liquidation, the secured bond holders will have a claim on these assets
so that their investment will be protected. In contrast, the unsecured debt holders do not enjoy
this form of protection. They accept a higher degree of risk which must be compensated for by
a higher level of return. (pages 61, 92)
Severance package This refers to the pay and benefits that an employee receives when their
employment contract is terminated. It will normally be partly additional salary as well as some
contribution to their pension fund. (page 144)
Share buyback This is an increasingly common method for companies to return cash to their
shareholders. The process is relatively simple. The normal technique is for companies to make
a ‘tender offer’ to all shareholders inviting them to sell their shares back to the company at a
set price. Second, a company might offer to buy from a particular group of shareholders and
lastly, the company could make a stock market purchase of its shares. (pages 153, 156)
Shareholders In most companies the shareholders provide the bulk of the long-term finance.
This makes them the key stakeholders in the business. They are the owners of the business and
the managers must always remember that they are merely acting as agents working on behalf
of the shareholders who are the principals. We normally assume that the primary objective of a
company is to maximise the wealth of its shareholders. In practice this is simplified to max-
imising the company’s share price. The shareholders range from private investors with small
227
Glossary
stakes in the business right up to the large financial institutions that often own a significant per-
centage of the equity of a business. (pages 12, 101)
Shareholders’ funds This is a measure of the total value of the shareholders’ stake in the
company. It is made up of the total share capital plus any reserves. (page 102)
Shorting shares This is used to refer to traders who sell a financial market security that they
do not yet own. In other words, they have not yet made an offsetting purchase. This is a very
risky activity as if the price of the financial market security rises the trader will have to pay an
ever higher price to secure the stock. The reverse process is when a trader goes long. This means
that they have bought some financial market securities which they have not yet sold. (page 73)
Sovereign entities This simply refers to a country or a supranational body like the World Bank
or the European Bank for Reconstruction and Development, which are both regular issuers of
bonds. (page 83)
Sovereign Wealth Funds (SWF) These are a form of investment vehicle used by countries to
build up financial assets with the funding coming largely from their reserves. The primary aim
of these funds is to make investments that will benefit the country’s economy and citizens over
the long term. The countries with a proliferation of SWFs will normally be those with significant
budget and trade surpluses which have allowed them to build up a pool of reserves that can
then be invested. In addition, the SWFs are also common among countries rich in raw materials
including the oil states. (page 210)
Special dividend This refers to the situation where a company decides to return any surplus
cash to shareholders through a one-off payment. This should be seen as an additional payment
on top of any expected normal dividend. The significance of labelling this dividend as ‘special’
is that it is a signal from the company that it will not be able to maintain annual dividends at
this higher level. It is a one-off benefit that shareholders should not see as becoming the norm.
(page 156)
Spreads This is a measure of the relative cost of issuing more risky bonds. It is best seen
with an example. Let us assume that the United States government has close to zero risk of
default. As a result a 10-year US Treasury bond might have a yield of 4.5 per cent. In con-
trast, a 10-year issue from Ford Motor Company which has significantly more risk of default
might have a yield of 6.5 per cent. This gives us a credit yield spread of 6.5 per cent minus
4.5 per cent ⫽ 200 basis points difference. If investors now start to buy lots of the higher
yielding (more risky) bonds, this could result in ‘tighter credit spreads’ as the relative cost of
these bonds falls. In this case the yield on the 10-year issue from Ford might fall back to
5.5 per cent. This would reduce the yield spread to just 100 basis points. This would be a
‘tighter credit spread’. (pages 76, 82, 129)
Stakeholders This refers to the various parties who have a share or an interest in a company.
This will include the shareholders, managers, employees, suppliers, government and the
members of the local community. (page 165)
Standard and Poor’s (S&P) 500 The S&P composite index is based on the market move-
ments of 500 companies that are listed on the New York Stock Exchange. This index is one of
the most widely used measures of US equity performance. (page 52)
228
Glossary
Sterling Libor or Euribor This is the rate used for loans made to low-risk banks in the London
The Euribor rate is the equivalent interbank rate but now for borrowing and lending euros in
the money markets. (page 208)
Stock dividends This is an alternative to an ordinary cash dividend. In this case the dividend
is paid in the form of extra shares. For example, a 5 per cent stock dividend means that each
shareholder gets an extra five shares for every 100 he or she owns. (pages 129, 156)
Stock split If a company is concerned that their share price has become too expensive they
can divide the shares into smaller units. For example, if a company’s market share price hits £14
this can be split into two £7 shares. The aim is to enhance the liquidity of the shares and there-
fore make it easier for smaller shareholders to buy their shares.
Structured investment vehicles (SIVs) These are large programmes created by investment
banks who seek to take advantage of the differences that exist between the cost of borrowing short-
term funds and the cost of borrowing long-term funds. SIVs will typically raise their cash in the
short-term commercial paper markets and then invest the proceeds in much longer-dated securities
such as bonds and mortgage debt. SIVs came to prominence during the sub-prime crisis as many of
them invested heavily in large amounts of collaterised debt obligations (CDOs). These CDOs are
packages of debt with various degrees of risk. Some CDOs invested heavily in the sub-prime mort-
gage debt. As a result of the default of some of these mortgages there are large numbers of CDOs
that will be worth much less than they are currently perceived to be worth. The investment banks
that own the CDOs were forced to write off a significant part of the value of these SIVs. (page 209)
Takeover This is the purchase of one company’s ordinary shares by another company. In this
process one company is seen to dominate the other. (page 165)
Tax relief on interest The tax treatment of long-term debt finance is very different from that
of equity finance. The interest on long-term debt finance can be charged against pre-tax profits,
which effectively means that the taxpayer subsidises the cost of debt finance. In contrast, divi-
dends are merely an appropriation of after-tax profits. As a result, any interest paid is an
allowable deduction from profits chargeable to tax. The existence of this tax relief on interest
payments has the effect of subsidising any highly leveraged deal. (page 139)
Tender offer This is simply where the takeover bid is made through a public offer which is
open to all shareholders allowing them to sell their shares at a price that is usually well above
the current market price. (page 170)
10-year bunds See BUNDS.
10-year Treasury notes See BENCHMARK 10-YEAR TREASURY NOTE.
The Treasury This is the part of the government that is in charge of official spending and
revenue decisions. In addition it plays a key role in the regulation of the financial services
industry. The Treasury is overseen by the Chancellor of the Exchequer. (page 209)
Tick size In most financial markets if you ask a market maker for a price, he/she will quote
both an ask price (buying price) and a bid price (selling price). The market maker makes a profit
229
Glossary
by setting the ask price above the bid price. This means that the market maker can sell the
security for a higher price than he or she buys it for. We call the difference between the ask and
bid price the spread. Suppose the ask price for a particular share is £14 and the bid price is
£14.20 p then the ‘bid–ask spread’ is 20 p. This can also be called the ‘tick’ size. (page 129)
Tight credit spreads See SPREADS.
Tightening monetary policy See MONTETARY POLICY.
Tranches This term is derived from the French word ‘tranche’, which means a slice. In this
context a tranche simply refers to the individual parts of a new bond issue. You might also see
the term ‘tap’ or ‘mini-taplet’ used. (page 77)
Transaction risk Type of currency risk that is associated with a particular financial commit-
ment entered into by a company that will involve a currency transfer. For example, if a UK
company borrows money in the US dollar and it is committed to make interest payments in
dollars, thecompany is exposed to transaction risk. So that each $1000 interest payment will
cost £500 at an exchange rate of £1 ⫽ $2. However, if the pound falls sharply in value so that
£1 ⫽ $1, the $1000 interest payment will now cost £1000. (page 181)
Translation risk Type of currency risk that applies to multinational companies which see their
consolidated financial accounts being affected by exchange rate movements. This might occur
when a company has various overseas subsidiaries and exchange rate volatility impacts on its
consolidated accounts when the subsidiaries’ figures are combined into the group’s overall
financial results. (page 181)
Transparency This refers to the way that a central bank makes information available about
the whole process of setting interest rates. At the end Article 6 there is a suggestion that the
current policy of selecting internal (from within the Bank of England) and external (from outside
the Bank of England) members of the MPC is non-transparent. This means that to any outsider
the selection procedure and criteria are unclear. (pages 27, 43)
Treasury bills US Treasury issues with a maturity from three months to one year. (page 52)
Treasury bonds US Treasury issues with a maturity of 10 years plus. (pages 29, 52)
Treasury notes US Treasury issues with a maturity from 2–10 years. (pages 29, 52)
Unemployment and non-farm payroll employment release This economic release is

made up of three parts. The first figure is the percentage rate of unemployment which is based
on a random survey of people. The second part tells us the change in thousands each month
in the number of people on companies’ payrolls. It excludes various special categories such as
the self-employed, unpaid family workers and the armed forces. The final measure looks at the
current trends in employee wage costs. It can provide early evidence of any rising cost-push
inflation. (page 51)
Unit trusts These are a very important form of collective investment. They allow private
investors to get exposure to a range of different sectors including the standard equity funds,
bond funds, money market funds and various property funds. The attraction of unit trusts is that
they allow fairly small investors to spread their risk across a more diversified portfolio. (page
111)
230
Glossary
Unsecured debt This is a much more risky form of debt instrument issued by companies. It
will not be backed by specific assets owned by the business. This means that in the event of a
default the holders are much less likely to receive their money back.
Upgrades Investment banks employ analysts who research the prospects for a company and
then place a target value for their share price. When the prospects for a company improve,
these analysts will raise their forecasts. This is called a profit upgrade. It might follow a new
investment opportunity or a change in the company’s business strategy. (page 116)
Valuation premium The correct valuation for the shares in a company is usually based on
important factors like the company’s future dividends or earning streams. It is normally the case
that we place a higher or premium value on companies that are expected to achieve signifi-
cantly higher growth rates than other companies in similar business sectors. (page 17)
Venture capital activity This is the form of finance that is normally provided to young start-
up companies. The idea is to help them survive and then expand in their early years of trading.
In return, the hope will be that they might provide an exceptionally high rate of return for the
venture capital company. This is a classic form of high-risk but high-return investment. (page
144)
Warrant This is a derivative instrument that gives the holder the right to purchase financial
market securities from the issuer at a set price within a certain time period. Warrants are com-
monly attached to certain new bond issues giving the holder the right to buy some shares in
the issuing company. (pages 62, 170)
White knight This is where the company being chased will seek out an alternative, friendlier
suitor that will form an alliance to act as a defence against the first bidder. (page 165)
Yankee bonds US dollar-denominated bonds issued by a foreign borrower in the American

domestic market. (page 76)
Yield curves A yield curve is a graphic representation showing the structure of interest rates.
It shows each bond yield plotted vertically with the maturity plotted horizontally. It is normal to
refer to the shape of the yield curve as being either upward sloping as the level of yields
increases in line with maturity. Or it might be downward sloping as the level of yields decreases
in line with maturity. Or it might even be relatively flat with yields broadly similar across the
maturity spectrum. (pages 27, 58)
Yields (and interest rates) When an individual or a company borrows money there is a cost
that they have to pay in order to obtain the funds. If it is a short-term loan (up to one year) this
is normally referred to as an interest rate. So we might take out a one-month bank loan with an
annual interest rate of, say, 8.5 per cent. This is the interest rate, or the cost of obtaining the funds.
If a company needs to borrow funds for a longer time period, this will normally be through the
issue of a bond market security, which is usually repaid at a fixed rate of annual interest (this is
called the coupon) until it is finally repaid on the date that it redeems or matures. The yield on the
bond issue is the cost to the issuer or the return to investor who buys the bond. (pages 62, 82)
Zero-coupon bond This is a bond that does not have any interest payable but will instead be
offered at a significant discount to the par value. This results in a large capital gain at redemp-
tion. (pages 62, 72)
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Z02_BOAK1818_02_SE_INDEX.QXP:FINA_ 3/11/09 08:26 Page 233
Index
Page numbers in bold type indicate Key Terms. Authers, John ,‘Stock splits: time to query
decades of dogma’ 126–9
Ainley, James 90
Airey, Dawn 17 Balls, Andrew, ‘Bernanke to give a taste of more
Alcatel of France 127 transparent Fed’ 24–5
Alliance Boots 134–8 bank failures 191–3, 198
Alliance and Leicester, taken over 191 Bank of America, bailed out 191
Alwaleed, Prince Bin Talal (Saudi Arabia) 206–7 Bank of England 26, 55, 209
Amaranth, collapse of 33 Financial Services Authority 193
Annual general meeting (AGM) 105, 170 interest rates and 40–41
Applegarth, Adam 203 lender of last resort 202
arbitrage 63, 73 Northern Rock and 200–1
Arcelor 162–5 role of 193
Arm Holdings plc 178–9 Bank of England Financial Services Authority
Armitage, Rod 99 and the Treasury 200
Arnold, G. bank’s analyst 75, 77
Corporate Financial Management Barber, Brendan (TUC) 135, 138
capital structure 93, 97, 103 Barclay’s Bank, fall in share price 37
corporate finance 8, 14, 18 Bauer Millett (car importer) 178
debt finance 68, 74, 78, 84 Bear Stearns 32, 36–7, 95, 195–6, 206
dividend policy 154, 157 Benchmark 10-year Treasury note 50, 52
equity finance 113, 117, 122 benign credit conditions 54, 57
mergers and acquisitions 166, 171 Berkshire Hathaway 127, 129
private equity finance 140, 145 Bernanke, Ben 24–6, 28
risk management and hedge funds 183 biotech industry, on pre-emption rights 99
stock market efficiency 130 Black, Steve 36–7
Essentials of Corporate Financial Management Black Wednesday (September 1992) 181
capital structure 93, 97, 103 Blacks Leisure 94–6
corporate finance 7–8, 14, 18 Blanchflower, David 42
dividend policy 154, 157 Blitz, Roger, ‘Logica’s chief quits in wake of
equity finance 113, 117, 121 warning’ 9–10
stock market efficiency 130 Bloomer, Jonathan 109
Financial Times Guide to Investing 113 BNP Paribas (French bank) 196
Arnold, Luqman 203 bond holders,
Arnold, Martin, ‘3i chief quits following steep commitment from company and 98
fall in shares’ 141–3 corporate failure and 91
Ashley, Mike 5–6, 94 bond yield spreads 66
Ashton, Kevin 11 bonds 37, 55, 76
Asian Central Banks, fears about 56–7 AAA rated 79, 82
Asian financial crisis (1997–8), LTCM and 186 auction process 63, 65–6
Association of British Insurers 99 convertible 62–3
Atrill, P., credit-rating 66
Financial Management for Decision Makers divergence in yields 63
166, 171 domestic 61
corporate finance 14, 18 Eurobonds 61
dividend policy 154, 157 foreign 61
equity process 113, 117, 122 relationship between yields and economic
mergers and acquisitions 166, 171 activity 58
stock market efficiency 130 warrants 62
233
Index
yield 62–3, 66, 82 collateral 1, 194, 197, 202, 207

zero-coupon 62, 71, 74 collaterised debt obligations 1, 205
book runners 63, 71, 73 commercial paper 62, 197–8, 200, 208
Boot, Jesse 136 companies’ objectives 3
BP 177, 180 companies’ cost of capital 89, 101–2
Bradford and Bingley, nationalisation 191 Confederation of British Industry (CBI) 99–100,
Braithwaite, Tom, ‘Woolies investor opposes 178
sale’ 118–20 surveys 180, 181–2
Braithwaite, Tom and Urry, Maggie, ‘Blacks Consumer Price Index (CPI) 42, 43
Leisure falls into the red’ 94–5 convergence 79, 81, 82
Branson, Sir Richard 203 convertible bonds 72, 73, 89, 90–91, 92
Break-even 95, 96 corporate brokers 100, 101
Breton, Thierry 164 corporate failure, costs of 88–9
‘bridge equity’ 137 corporate finance, role of financial manager 1–2
Bridgewell Securities 12 corporate governance 5, 7
brokerage commissions 127, 129 Corporate Governance at Foreign and Colonial
Brown, Gordon (UK PM) 203–4 Asset Management 100
Bubb, Nick 135–6 Corus Steel 33
budget deficit 64, 66 credit crisis 79–81, 131, 173, 193, 206, 207
Buffett, Warren 127, 129 born in USA 205
Buffini, Damon 135 global 79, 82
building societies 21–2 pressure on UK retailers 118–19
Buiter, Professor Willem 41–2 credit default swaps (CDS) 80–1, 83
Bull–Dog Sauce 167–9 credit ratings
Bulldog bonds (UK bonds) 75–6 Argentina 174
Burgess, Kate, ‘UK investors dig in over pre- bond 66
emption rights’ 98–100 Moody’s 66–7, 174
Burke, Ian 152 credit ratings agencies 34
business risk 89, 95–6, 108, 119 credit risk 81, 173–5
buyout deals 133 credit risk premium 80, 83
credit swaps market (CDS) 82
capital calls 142, 144 CSR (Bluetooth technology group), hedging
capital expenditure 17, 149, 154 and 178
capital structure 87–95, 92 currency risk 176, 181
role in corporate finance 90 three main types 179–80
Carayon, Bernard 164
central banks 21–2, 30 Darke, Neil 152–3
fixing a liquidity crunch 197, 200 Darling, Alistair (UK Chancellor) 194, 200,
hawkish and dovish 30–31 203–4
role of 23–4 press conference 202
Chapman, Sir Colin 17 De La Rue 149, 155–6
cheap credit 195 debt 61–3
Chicago Mercantile Exchange 127 commercial paper 62
chief executive officer (CEO) 11, 12 definition of 61
Chung, Joanna, ‘Flight to liquidity pushes fixed-income securities 62
eurozone bond yields apart’ 79–82 secured (debentures) 61
Citigroup, secured and unsecured 89, 92
bailed out 191 senior unsecured 62
credit crisis 206 subordinated or junior 62
Greece 64 debt capital 88
research 178 debt finance 61–3
Samurai bond sale 75 need for cheap 131
UK 110, 177–8 default 38
US banking giant 76 company 23
US government acts to save 205–6 on loans 13, 33, 38
Clarke, Jim 152 default rates 33
class B redeemable shares 153, 154 defence mechanisms 161
234
Index
deficits budget 63 Fed funds (effective) 207, 208

delisting 6, 7 Fed funds rate 24, 26–7
diluted (shareholdings) 100, 102 Fed watching 24–5, 26
discounted cash flow valuation 15, 116 Federal Open Market Committee see FOMC
dividend policy 147–9 Federal Reserve Bank 24, 40, 42, 207
clientele effect 148 credit crisis and 194, 196–7
information contained in dividend decisions Fed funds rate 26–7, 31, 200
148–9 Fed watching 26
dividend valuation model 147 ‘Humphrey Hawkins Testimony’ 26
dividends 149, 156 FOMC 24–7, 30–31
Dollé, Guy 162, 164–5 repo operation 197
‘domino effect’ 173 website 45
Done, Kevin ‘Sir Stelios spells out fears for financial institutions 21–3
easyJet’ 15–17 definition 21
Dong-hee Han 163 financial intermediaries 125
Dorgan, Philip 5 financial manager, role of 1–2
Doukas, Petros 64–5 financial markets 1, 24, 47–8
dovish members of Central Banks 30 bond markets 47
Dow Jones Industrial Average 50, 52, 127, 128, derivative markets 48
208 equity markets 48
credit crisis and 195 foreign exchange markets 48
Drax Group special dividend 148 key question 200
money market 47
East, Warren 178 standing at a crossroads 54
easyJet 15–17 US employment data release 49, 50–51
ECB 26, 40, 42, 55 financial risk 108, 119
credit markets crisis and 194, 197, 200 Financial Services Competition Scheme 194
and key interest rate 58 Financial Times,
ECB Council 209 Companies and Markets section
economic releases, impact of 50–51 bank failures 211
economic risk 179, 181 capital structure 93, 96, 103
efficiency, use of the term 123 corporate finance 2, 18
efficient market 116 debt finance 67, 77, 84
efficient market theory (EMT) 124 dividend policy 157
emerging markets 108, 115, 116 equity finance 116, 121
employment data release from US 49–51 investment banks 21, 30
equities 37, 105 risk management 182
equity capital 88 stock market efficiency 130
equity finance 1, 105–7 Lex column 47, 55–9
equity fund-raising 99, 102 Alliance Boots deal 137
Euribor rates 197–8 role of 57, 59
Eurodollar deposits 197, 208 ‘Valuing Sainsbury’s’ 114–15
European bond markets 79–83 Lombard Column 6
European Central Bank see ECB FOMC 23–6, 27
European Commission, pre–emption rights and Foreign and Colonial Asset Management 100
99 Fowler, Stuart 151, 153
European Union authorities, UK population and fraudulent risk 175
100 Freddie Mac and FannieMae, bailed out 191
Eurostat 41 FSA 194, 209
Eurozone 56, 81, 82 Northern Rock crisis 191, 194, 200–201
Evans, Mike 109 FT reporters, ‘Surprising US job creation data
ex–rights price, calculating 89 rally stock markets and dollar’ 49–50
exchange rate mechanism (ERM) 180 FTSE Euro 195
exchange rate risk 175, 177 FTSE Eurofirst (300) 208
exotic products 70, 73 FTSE–100 128, 141–2, 144, 181, 186, 208
fall 195
Fama, Eugene 124 share prices 127–8
235
Index
FTSE–350 177, 181 Hands, Guy 137

fund managers 186, 188 Hardy, Russell 94–5
Futures Market (Liquid futures market) 24, 43, Hargreaves Lansdown 109–110
83 Hargreaves, Peter 109–111
Harris, Chris 178
G8 (Group of Eight), transparency initiative 185, Hawkish, Central Banks and 25, 30
187 HBOS, take over 191
gainsay 99, 102 headcount (India) 178
Garrahan, Matthew, ‘MyTravel Shareholders hedge funds 38, 71, 73, 175–6, 208
offered 4% in £800m debt–to–equity activist 185, 187, 188
restructuring’ 90–91 Bull–Dog Sauce and 169
Gave, Louis–Vincent 80 German global database and 185
GaveKal European Divergence Fund 80 global macro strategies 187
gearing 87–9, 96 investment strategies 186–7
General Electric (GE), share price 126–7, 128 managers and 25, 187, 188
Germany, MW Tops 185
10-year bunds 55, 58, 83 pensions and 186
30-year bunds yield 66 regulation 176, 187–8
AAA rated government bonds 82 risk management and 173–6
bund market 81 US and 175
Bunds 80, 89 what they do 184
DAX index 54, 56, 57 hedging 181
global database of hedge funds 185 Hilco UK 118–19
liquid futures market in 80–81 Hollinger, Peggy, ‘Mittal goes on Arcelor charm
transparency 185 offensive’ 163–5
Giles, Chris and Daneshkhu, Scheherazade, Hope, Kerin, ‘Athens prepares 50–year bond
‘Bank to give better guidance over rates’ issue’ 64–5
40–41 housing market, credit crunch and 49, 55, 80,
GlaxoSmithKline 177, 180 195, 198, 205
global credit crisis 79, 82 HSBC 177, 180
global warming, Blacks Leisure and 95 Hughes, Chris,
globalisation 33, 35 ‘Exporters curse dollar’s drag on profits’
Goldman Sachs 21, 34, 36, 203–4 177–8
Google share price 128 ‘Shareholders taking a stand on handouts’
government debt 82 150–53
Government of Singapore Investment Hughes, Chris, Braithwaite, Tom and Taylor,
Corporation 205, 207 Andrew, ‘Boots provides takeover acid
Greece, new government bond issue 64–5 test’ 134–6
Greenmailer 161, 168–9, 170 ‘Humphrey Hawkins Testimony’ 26
Greenspan, Alan 24–6, 55
Griggs, Tom, ‘De La Rue pays special dividend’ ‘indexed funds’ 124
155–6 Industrial and Commercial Finance Corporation
group of seven 40, 44 142
growth capital deals 133, 141, 143, 144 infrastructure 133, 141, 143, 144
growth strategy 15, 17 initial public offers (IPOs) 35, 38, 102, 107,
growth/mature company 16, 17 111
Guerrera, Francesco, Baer, Justin and Grant, institutional investors 112
Jeremy, ‘JP Morgan to cut prop trading interbank markets see Libor
desk’ 36–7 interest rate risk 174–5
Guerrera, Francesco and Beatte, Alan ‘US intermediaries 127, 129
government agrees to take biggest single internal rate of return 133, 138, 139
stake in Citigroup’ 205–6 investment banking 32–5
Guha, Krishna, Mackenzie, Michael and Tett, Investment Banking Division (IBD) 35, 101
Gillian, ‘Fresh turmoil in equity markets’ investment banks 21–3, 34–5, 37–8, 101
194–5 investor protection 98–100, 102
investor relations 5–6, 7
Haji-Ioannou, Sir Stelios 4, 15–17 investors 91
236
Index
Japan, risk 174

Bull Dog Sauce 167–8 list 109, 111
closure of private banking business 75 Litvak, Karina 99
convertible bonds 70–73 Lloyds TSB, bailed out 191
credit market crisis and 194 Loeys, Jan 198
global convertible arbitrage hedge funds 71 LogicaCMG 4, 9–11
government bonds climbing 55 London Interbank Offered Rate see Libor
JFE steel corporation 162–3 London Share Service 107
Johnson, Steve 119 London Stock Exchange 102, 110
Jones, Scott 168 Nasdaq’s bid 32–3
JPMorgan 24, 36–7 pre-emptive rights and 99
Junck, Roland 165 long-short equity 176, 186–7
Juncker, Jean-Claude 164 Long-Term Capital Management (LTCM) 186
long-term finance 9, 12
Kastner, Michael 54 low-cost airlines, not recession proof 16
Kawasaki Steel 162–3 Lucas, Gerald 55
Keating, Seamus 10 Lucent Technologies 127
Kenny, Paul 135 lyons (liquid yield option notes) 71–2, 74
Killgren, Lucy and Blackwell, David, ‘Sport
Direct warning stumps investors’ 5–6 McCafferty, Ian 178
King, Mervyn 40–42, 209 McCulloch, Russ 162–3
King, Stephen 155 McKenna, Jim 10
Kingman, John 203 Mackenzie, Michael, ‘Repo market little known
Kinsley, Adam 99 but crucial to the system’ 196–7
KKR (Kohlberg Krvis Roberts) 134–8 Mackenzie, Michael, Beales, Richard and
Kofinakos, George 64 Chung, Joanna, ‘Bond Yields spark credit
Kohlberg Kravis Roberts see KKR concerns’ 54–5
Kretzmer, Peter 49 Mackintosh, James, ‘Facing down the threat of
tighter rules’ 184–6
Lake, Gareth 71 Malek, Stan 80
Lansdown, Stephen 109–110 Maloney, Sean 81
Large, Sir Andrew (MW Tops) 185–6 Man Group 195
Larsen, Peter Thai, ‘How long can the good management buyouts (MBOs) 131–3
times last? Bankers cautious despite bids margins 115, 116
and bumper bonuses’ 32–5 market buyouts 143, 144
Larsen, Peter Thai and Hume, Neil, ‘Bank throws market capitalisation 149, 156
Northern Rock funding lifeline’ 200–1 market risk 174
Lazard Brothers 33–5 Marshall Wace (MW) 185
leases 119, 120 Masuda, Takashi 70
legal risk 175 Matildas (Australian bonds) 75, 76
Lehman Brothers 25, 32, 191, 206 maturity yield curves and 27–8
lender of last resort 193, 202, 209 Maughan, Simon 34
leverage 33, 87–8 Mellors, Bob 5
leveraged buy-outs (LBO) 34, 38, 132–4, 137, mergers 165, 167, 205
139 mergers and acquisitions 34, 147, 159–61
Lex Column, ‘Bond market sell-off’ 55–9 conglomerate 160
Libor rates 41, 43, 47, 193, 197–8, 208 economic reasons for 160–61
credit crunch and 195–6, 197–200 friendly 159
role of 199 horizontal 159
Lipsky, John 24–5 hostile 159
liquidity 65, 80, 128 vertical 159
bond markets 63 mergers, takeovers and acquisitions (MTA) 161
credit crisis 196–8, 200 Merrill Lynch 33, 71, 191
desirability of 128 Meyer, Larry 25
excessive/bubble? 34 Michels, Sir David 17
investment bank and 21 Millets stores 94–5
premium 80, 83 Mimura, Akio 162
237
Index
Mittal, Aditya 165 Philippot, Gerard 11–12

Mittal, Lakshmi 162–4 Pike, R. and Neal, B.
Mittal Steel 162, 163–4, 164–5 Corporate Finance and Investment
Monetary Policy Committee (MPC) 23, 41, 42 capital structure 93, 97, 103
Monopolies and Mergers Commission 89, 99, corporate finance 19
100, 102 debt finance 74, 78, 84
Montagnon, Peter 100 dividend policy 154, 158
Moody’s credit ratings 64–7, 83 equity finance 113, 117, 122, 140
‘moral hazard’ 202 mergers and acquisitions 166, 171
Morgan Stanley 33, 36, 150–53, 152, 178 private equity finance 140, 145
stock market growth 178, 180 risk management and hedge funds 183
Morley Fund Management 11–12 stock market efficiency 130
Mortgage-backed securities 1, 38, 193, 194–5, Pilbeam, K. International Finance 69, 74, 78, 84,
205, 207 179, 183
Murakami, Yoshiaki 70 plain vanilla bonds 71, 74
Murphy, Dominic 135 poison pills 161, 167–9, 170
Myners, Paul, on pre-emption rights 98–9, 100 Posco Steel (South Korea) 163
MyTravel 3, 90–91 Pre-emption rights 98–100, 101
preference/preferred shares 89, 91, 92, 193,
Naghshineh, Ardeshir 119 206–7
Nakamoto, Michiyo, ‘Poison pill’s strength price-earnings (PE) ratio 110–112, 155–6, 157
under analysis’ 167–9 Prichard, Jonathan 5
NASDAQ Composite 50, 52 primary and secondary markets 23, 38
New York Stock Exchange 127 principle and proprietary trading 23
Next 178, 180 private banking 75, 77
Nikkei 225 208 private equity 107, 115, 134, 139
Nikkei Average, fall in 195 conditions for deals 131
Nikko Citigroup 71, 75 four main forms of divestment activities 132
Nippon Broadcasting Systems 168 how are deals financed? 133, 137
Nippon Steel 162–3, 164 impact of credit crunch 133
nominal price 118, 120 meaning of the term 137, 139
nominal share price 125–7, 129 motivation for deal 138
non-executive chairman 9–10, 13 private equity finance 131–3
non-executive director 10–12, 17 private equity group 3i,
non-voting preference shares 91, 92 history 142
nonagenarian 127, 129 how positioned 143
Northern Rock, main problems in 2009 142–3
how crisis started 195–6 what was future like for 143
impact on 196 private equity groups 143
how government and Bank of England acted private equity investors 107, 110, 136
to save 202 profits 3
nationalisation 191–3, 194, 203–4 warning 7, 10
property assets 108, 114, 115
O’Hagan, Ciaran 80 proprietary trading 37, 38
operational risk 174
Quantas airline 33
Palmer, Maija, ‘Investors expecting change at Queen, Michael 141–2
LogicaCMG’ 10–11 Quinn, Leo 155
Pandit, Vikram 205
Panmure Gordon 5–6 Ratner, Richard 5
Parker, George and Larsen, Peter Thai, ‘Brown Read, Martin, left Logica 9–11
saw no other option’ 203 real estate (property) 37, 38
Paulson, Henry (US Trade Secretary) 202 redeemable ‘B’ shares 149, 152, 154
pension fund deficit 119, 120 relationship between bond yields and economic
Pessina, Stefano 135–6, 137 activity 58–9
Peston, Robert 202 Repo Rate 41, 42, 192–3, 196, 208
Petitgas, Franck 33 how it works 199–200
238
Index
safety valve in times of stress 199 losers in UK and USA credit crunch 207
repurchase market see repo rate MyTravel 90
retail banks 21–2 options for 89
retail deposits 193, 202, 209 ordinary and risks 91
Retail Price Index (RPI) 42, 43 relationship with a company 2, 9
retail and wholesale deposits 193 rights of 105
return on new issues investment bank and 21 takeover bids and 33
Richardson, David 5 warrants and 169
rights issues 89, 98, 168, 170 shareholders’ funds 102
risk 142–3 shares 98
aversion 80–81, 84 authorised 106
economic 176, 179 convertible 107
investment bank and 21 limited liability 106
premium 79, 81, 83 ordinary and ‘risk capital’ 91, 105
reduction of 37 participating 107
‘risk capital’ meaning of 105 preference 106
risk management and hedge funds 173–6 cumulative 106
rival bid 119, 120 redeemable 106
Rogers, Jason (Bank’s analyst) 75 Sherwood, Charles 134
Ross, Wilbur 34 shorting its shares 71, 73
Royal Bank of Scotland bailed out 191 Singapore Investment Corporation, government
Rudd, Sir Nigel 135, 137 of 206, 207
Ruskin, Alan 49, 197 Solbes, Pedro 164
Ryanair (Ireland) 15 Solomon Brothers 186
Soros, George 175, 177, 187
Sainsbury, David 115 sovereign entities 63, 80, 83
Sainsburys 114–15, 134 sovereign wealth funds (SWFs) 80, 193, 207,
sale and lease back 108, 116 210
Samurai bonds (Japanese bonds) 75–6 special dividends 148–9, 152–3, 155, 156
Sanchanta, Mariko, Spikes, Sarah ‘Hargreaves Lansdown soars on
‘Discussions unlikely to yield white knight’ debut’ 110–111
162–3 Spikes, Sarah and Saigol, Lina ‘IPO values
‘Record samurai deal by Citigroup’ 75 Hargreaves at £750m’ 109
Sandler, Ron 203–4 Spin-offs 132
Sands, Hector 209 Sports Direct 3, 5–7, 94
SARS 167–8, 169 spread (tick size) 80–82, 127–8, 129
secondary markets 35 stakeholders 163, 165
secured and unsecured bonds 89 Standard and Poors (S&P) 500 index 50, 52
secured and unsecured debt 89, 91, 92 tumble in credit crisis 54, 195
Securities and Investment Board 185 Steel Partners (US hedge fund) 167–9
securitisation 201, 209 Steinbrück, Peer 185
sell-offs 132 Sterling libor or Euribor 208–9
Sels, William 198 Stirling, Euan 152
severance package 141, 144 stock dividends 125, 129, 156
share buybacks 149, 150–52, 153, 156 stock market efficiency 123–8
share price valuations 107, 115 ‘stock’ or ‘script dividend’ 147
share prices, stock spread 125, 127–9
go into reverse 16 strong pound effects of 177–8
investors and 124 structured investment vehicles (SIVs) 1, 193,
volatility of 70–71 209
shareholders 1, 3, 98, 100, 101 Stutterheim, Cor 10–12
activist 9, 12 sub-prime crisis 193, 195, 198
Blacks leisure and 95 sub-prime mortgages Citigroup and 206
buybacks and 153 Sugar, Sir Alan 16
clientele group 148 systemic risk 175
communication with 5–6
Japan and 168–9 Takashi, Masuda 70
239
Index
takeover 159, 164–5, 191 upgrades 115, 116

bids 33, 135, 162
Tata Steel 163 Vaitilingam, R. Financial Times Guide to Using the
tax relief on interest 135, 139 Financial Pages 53, 158
tender offer 168, 170 Valdez, S. An Introduction to Global Financial
Terra Firma 134–6 Markets 31, 39, 69, 78, 85
Tesco 114–15 valuation premium 15, 17
Tett, Gillian ‘Growing sense of crisis over venture capital activity 131, 133, 143, 144
interbank deals’ 197–8 Villepin, Dominique de 164
‘tick’ size or spread see spread (tick size)
tight credit spreads 76–7 warrants 161, 168–9, 170
tightening monetary policy 25, 30 Watson, D. and Head, A.,
tranches 75–6, 77 Corporate Finance Principles and Practice
transaction risk 177–8, 181 capital structure 93, 97, 103
translation risk 179–80, 181 corporate finance 19
transparency 24–5, 27, 30, 40, 43–4, 185 debt finance 69, 74, 78, 85
Treasury Bond Market (US) 29–30 dividend policy 154, 158
Treasury , the 209 equity finance 113, 117, 122, 140
negotiating team 203 mergers and acquisitions 166, 171
Tuppen, Ted 152 private equity finance 140, 145
Turner, David ‘Convertibles stage return to risk management and hedge funds 183
fashion’ 70–72 stock market efficiency 130
Waugh, Robert 152–3
unemployment and non–farm payroll weak dollar 177–9
employment release 51–2 Weber, Axel (ECB council) 198
UniCredit analysts 197 websites,
Unilog 10 3i 145
United Kingdom Artemis 113, 115
$2 pound put pressure on companies in Bank of England 44, 45, 211
177 Barclays Capital Investment Bank 39
exit from exchange rate mechanism Bureau of Labor 53
(September 1992) 175, 177 ECB 59
forced to save Northern Rock 192 European Union’s 166
gearing and 87 Federal Reserve 31, 45, 211
nominal price of shares 127 Financial Times 8, 68
pre-emption rights and 98–9 GlaxoSmithKline 182
United States Goldman Sachs 39
bailout of Citigroup 192 JP Morgan 39
benchmark 10-year Treasury note 50, 52, Kohlberg Kravis Roberts (KKR) 140
55 Nomura 39
bond markets 56–7 Tesco 13
Dow Jones Industrial Average (DJIA) 52 Weinberg, Perella recruitment of bankruptcy
fears about housing market 55 adviser 34
Federal Reserve 194 white knights 161, 162, 164–5
financial leverage 88 wholesale deposits 193, 202, 209
government acts to save Citigroup 205 Wilders, Erik (DSTA) 80–81
hedge funds and 175 Winters, Bill 36–7
NASDAQ Composite 52 Wipro 10
non–farm payroll employment release 51–2 WM-Data 10–11
origins of private equity 139 Woodthorpe, Alex 71
release of employment data from 49–51 Woolworths 118–19, 191
role of financial markets 24 how did financial risk impact on 120
S&P composite index 52 Worcester sauce offer by Steel Partners 167–8
fall in 56
sub-prime market 80, 192 Yamanouchi, Nobu 167–8
Treasury bond market 23, 26, 29–30, 55 Yankee bonds 75–6
unit trusts 107, 110, 111–12 Yea, Philip 141–2
240
Index
Yield curves 27, 58 role of 23

flat 25–6, 29, 64–5
inverted or downward–sloping 29 zero coupon bonds 62, 71, 74
normal or upward sloping 28
241

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“The Blog in general provides an excellent “As a BA (Hons) Business Studies student it is

Reading and Understanding the

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Reading and Understanding the

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First published 2008

© Pearson Education Limited 2008, 2010

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To my Mum and Dad with thanks for all their support.

About the author xiii

Poor communications puts Sports Direct off track

Activist shareholders demand change at Logica

Not so easy for Sir Stelios!

Financial markets watch the new Fed chairman

The roller-coaster life of an investment banker

More transparency needed at the Bank of England

At 1.30 p.m. in London all eyes are on the screens

Financial markets standing at a crossroads

Greek government launches new bond issue

Japanese convertibles back in fashion

Bulldog, Yankee and samurai bonds . . .

European bond markets start to diverge

MyTravel on the brink

Blacks Leisure hit by global warming

Looking for the ‘right’ way forward

Hargreaves’ founders float all the way to the bank

Good value at Sainsbury’s?

As Woolworths died we try speed-dating for the last time!

Company shares split down the middle

Private equity firm fills its Boots

Economic slowdown provokes unease at private equity firm

Have share buybacks gone too far?

Printing money pays big dividends for De La Rue

Sophisticated European company into hot metal seeks more sympathetic

Can Japanese sauce spice up US hedge fund?

The $2 pound puts pressure on UK companies

So tell me, what do these hedge funds actually do?

Bank 1: Northern Rock: the road to nationalisation

Article 37 Brown saw no other option 203

Bank 2: Back in the USA, the government acts to save Citigroup

About the author

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