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The Actuary The magazine of the Institute & Faculty of Actuaries
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Principles of Corporate Finance

Jeremy Goford, president of the Institute of Actuaries, has been extolling actuaries to read more widely. One of the first books Jeremy recommended in his presidential address last year was Principles of Corporate Finance by Richard Brealey and Stewart Myers. This book has been the standard introductory text to corporate finance for MBA students, and others looking for an understanding of the subject, for over 20 years and is now in its seventh edition.

The latest edition has overhauled the look of the book to give it a more modern feel. It comes with a CD containing extra material, interactive Excel-based tests, and links to a wide variety of finance-based websites – particularly useful for those hands-on actuaries. The coverage of real options has been considerably expanded to give more detailed coverage on valuation and a wide range of practical applications.

Why should actuaries read this book?

Many actuaries who qualified five or more years ago will have had little exposure to financial economics and corporate finance in their actuarial training. Recently these areas have moved from the wings to centre stage for actuaries in their daily working life; realistic balance sheets and risk-based capital are two of the more recent examples. Those wishing to expand their knowledge and learn more about corporate finance would be well advised to read this book.

The first four parts of the book and part seven cover material familiar to actuaries, such as value, risk, capital budgeting, market efficiency, and debt financing. The approach taken by the authors is a pragmatic, rather than deeply theoretical one, with many practical examples and interesting insights into financing decisions. These often give a different viewpoint from that an actuary might usually have.

Part five, ‘Dividends and capital structures’, presents the classical Modigliani and Miller (MM) arguments about the irrelevance of corporate structure, ie the balance between debt and equity financing is irrelevant, under certain idealised conditions. These conditions are then relaxed and modified versions of the MM arguments are shown to still be useful in real world situations. The sections on the cost of capital make interesting reading in light of the arguments actuaries traditionally rely on to justify the risk discount rates used in embedded value calculations.

Part six gives a readable, but rather simplistic, introduction to options. Most actuaries interested in learning more about options would probably be better served by reading Hull’s standard textbook on the subject ‘Options, futures and other derivatives’. The new chapter on real options shows the option-like nature of many business decisions that would at first glance not appear amenable to option pricing techniques. When viewed from the perspective of financial economics these business decisions can often be deconstructed into contingent cashflows and valued using option techniques.

Later chapters

Financial risk management is the focus of part eight. The authors look at basic hedge techniques including the use of forwards, futures, swaps and options. Again, those interested in hedge techniques may be better advised to read the relevant chapter of Hull or any of the specialist publications on this subject. Part nine focuses on financial planning and short-term management; again, most of this area is likely to be familiar to actuaries.

Part ten is topical as it covers mergers, corporate control, and governance. The mergers chapter provides a readable tract on both sensible and dubious reasons for mergers. In particular it demonstrates the weakness of the argument that the merged entity will have borrowing costs lower than those of the individual entities. A brief guide to the mechanics of mergers and how to estimate costs are also covered. The mergers section is concluded with an interesting discussion on whether mergers generate net benefits. The structures and control of firms and the roles of private equity firms, such as KKR, in leveraged buyouts are discussed at length. The different structures of firms worldwide are compared, and the effects of structure on control and governance discussed, although corporate governance is given much less emphasis than is current in the financial services industry.

Further reading

Although actuaries can take much information and practical knowledge from this book, its introductory nature and general lack of detailed mathematics is unlikely to satisfy those looking for an in-depth and mathematically rigorous treatment of the subject. However, it remains an excellent introduction to the subject and a pointer to areas where further reading would be useful.

cover

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