Advanced Corporate Finance Video Conference 1: Introduction.
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Transcript of Advanced Corporate Finance Video Conference 1: Introduction.
Advanced Corporate Finance
Video Conference 1: Introduction
IntroductionsCarlos BellónAssistant Professor Universidad Carlos III de MadridPhD from WhartonMBA from Wharton5 years as Investment Banker in London
JPMorgan Citigroup
Contact [email protected]: +34 669 42 70 26Skype: belloncj
Who am I?
What can we do together?
Did you sign up for this?
Finance is a craft, not a science Beware snake oil
salespeople Triangulation Different techniques
are either all essentially the same… or they are wrong
All models are useful in some way
Value can be in the eye of the beholder
Techniques are meant to explain – Finance is not physics
At your level, Corporate Finance is subtle.
How this course builds up on others Some things become more subtle, a little
different CAPM Modigliani & Miller
Subtle effects are seen in razor-thin environments LBOs Bankruptcy Agency problems Restructuring Strategic turning points
Finance is the craft of risk weaving
Weaving strands of risky flows of money
What risks do we face?
Who bears what risk?
What risks are contracted away?
What risks are priced?
What risks are shunned?
Sources of Risk Risk components
Solvency v. Liquidity Risk – Uncertainty – Leverage Risk and mismatching (duration, etc.) Forecasting risk (differences of opinion, etc.)
Risk threads Horizontally – different drivers Vertically – order of payment Financial engineering
Course Plan
Course Objectives
Tools mastered Concepts understood
How to identify “separable” sources of risk
Sensitivity analysis Value decomposition
through multiples Levered transaction
pricing
Impact of financial structure on value
Agency costs Solvency and
liquidity risk Value transfer
between stakeholders
State-contingent pricing
Agenda S2. VC: Exploiting different views on valuation
Saturday, September 27 S3. Heinz Revisited
Monday – Thursday, September 29 – October 2 S4. USX Corp – Conglomerate discounts and solutions
Monday – Thursday, October 13 - 16 S5. VC: Bundling and unbundling risks
Saturday, October 18 S6 & S7 Kerr-McGee
Monday – Thursday, November 3 - 6 Monday – Thursday, November 10 – 14
S8. The Road Ahead Monday – Thursday, November 24 - 27
Taking Advantage of the Blended Method Video Conferences for Understanding
Detailed discussions will be redirected to specific chats Interactive: Ask questions!
How-to Sections Videos, Teaching Notes, Examples Chats for detailed problem-solving and individual attention
Case Online Forums are for induction and deduction Apply what we know to real world problems Discover holes in our understanding through real world
“puzzles” Save chat rooms Where to find more? Chat rooms for “in the real world…”
Case Discussion in the Online Forums A few main lines of inquiry that I will set up at
the start We are free to branch out in any direction, but
thread postings must adhere to topic in the title
Freedom to go in as much depth as you want… …. Or as little
Online Participation (30% of grade) Come prepared
Read the case Solve the case
Socratic Method Be incisive, but be civil We are here to polish each other’s understanding
That includes me!
Grading will be based on how much your participation contributes, not on whether the answer is “right”
Online Chat Etiquette Instructor question: “What do you think of
…..?” Student 1 answer Student 2 answer
Student 1 comments Student 3 comments
Student 1 replies
Instructor pitches in and redirects discussion Student 3 answers ….
Group Case (40% of grade) Due late on the Saturday before the beginning
of S7 (November 8) Short, but detail-heavy summary Questions will be made available after online
session 5, before the basics of the case will be discussed
All answers will be made public Differences will be debated in the online
session
Final Exam (30% of grade) Short exercises
Multiple choice questions
Paragraph-long essays on more conceptual issues
Key Concepts and their Extensions
Intrinsic Value Expectations Discount rates
Economic Balance Sheet Where value comes from and
who gets to keep it
Patient investor approach to value
RETURN PROCESSINVESTMENT
DISCOUNTED AT OPPORTUNITY COST OF CAPITALVALUE
MONEY FLOWS
NPV = PV(Flows; r) – InvestmentReturn = Flows / Investment
Expected Cash Flows
The Source of Most of the Evil in the World
“Expected” vs. “Hoped For” Profits
All valuation formulae deal with uncertainty through the discount rate
Expected, not Spot-On Math requires 50% of
probability mass above and below expected value
Great opportunity for constructive use of scenario planning
How to calculate Expected Profits?
Here is where we introduce idiosyncratic risk factors that should not be taken into account in the discount rate
Extrapolative Models Use previous values of the variables
Index Models Use other variables to forecast profits Knowledge of the business (“Structural models”)
Permanent v. Transient components of performance “Adjusted” or “Clean” forecasts Careful with EBBS
How to forecast?
Real Life Martingales vs. Mean Reversion
Martingale ExampleMean Reversion Example
If you are lucky once, your base level increases
“Sticky” / Repeat business
Phone company clients
Other examples?
If you are lucky once, your base level is unchanged
“One-off” / No memory business
Convenience store clients
Other examples?
What to forecast (Divs, Income, CFs)?
Discount Rates
Measuring Risks
Required return on assets – According to M&M this is invariant to capital structure and only depends on economic parameters
Required return on debt – increases with leverage as does risk of bankruptcy and is only equal to interest rate when debt trades at par
Required return on equity – increases with leverage but at a certain point levels off – CF to Equity should be discounted at this rate
Weighted Average Cost of Capital (WACC) – Depends on leverage and used to discount UFCFs and get to EV
Risk-free rate
What discount rates are there?
Discount rates and their relationships
Modigliani & Miller (M&M)
• Constant CFs• Constant D• PV (TS ; rD )
rW = rA [1 – T(D /V)]
Milles & Ezzel (M & E)
• Arbitrary CFs• Constant D/E (mkt)• PV (TS ; rD )
rW = rA - T rD (D/V)[(1+rA)/(1+rD)]
Risk and Variability are NOT the same
You may care about risk
Math only cares about variability
Time value of money Value of risk
What kind of risk do I care about Semi-variance would be best – We can forget
about it right now What sources of risk do I care about
Diversifiable v. systematic risk How much do I care?
“Price” of risk – This is where all hell breaks loose
Characteristics of a discount rate
As long as assets are not perfectly correlated, diversification reduces overall risk
When the number of assets is long all that matters is their loading on to the diversified portfolio: β
Diversifiable risk
0 5 10 15 20 25 30 35 40 45 500%
10%
20%
30%
40%
50%
Standard deviation of Portfolio Returns as a function of number of stocks in
portfolio
Empirical example
Source: E. J. Elton and M. J. Gruber, "Risk Reduction and Portfolio Size: An Analytic Solution”, Journal of Business 50 (October 1977)
Systemic Risk
Depends on the contribution of the investment to the undiversifiable source of risk: Its β
Problems (even taking CAPM at face value):
1. Theoretical finance assumes this is a stable structural parameter
2. Empirical finance measures purely statistical properties of the correlations
Required Return for Extra Risk
β is difficult enough to estimate…
Citigroup Boeing
10 yrs v. S&P
1 yr v. S&P
… no reason it should be stable… β correlates firm returns (therefore expected CFs)
with market returns Structural components of β (CF growth) Are they likely to stay constant over long periods?
… and nobody can estimate EMRP
…
How to Create Value andWho Gets to Keep it?
The “Economic Balance Sheet”
The “Economic” Balance Sheet
LT DEBT €90
EQUITY €30EQUITY €30
FIXED ASSETS €70
FIXED ASSETS €70
ST ASSETS €70
ASSETS €140 LIABILITIES €140
INVESTED CAPITAL €120
CAPITAL EMPLOYED
€120
ST LIABILITIES €20
WORKING CAPITAL €50
LT DEBT €90
Explicit sources of value: “Managerial” B/S
LT DEBT €90
EQUITY (@ MV) €60
FIXED ASSETS €70
WORKING CAPITAL €50
WARRANTIES €10
BRAND €40SOCIETY
IRS
CUSTOMERS
ALLIES
DEBT HOLDERS
EMPLOYEES
BRAND
LT ASSETS
PROCESSES
TEAMS
CULTURE
STRATEGY
EQUITY HOLDERS
WK
INVESTED CAP CAP EMPLOYED
EQUITY €30
“Creating Value” Through Leverage
EQUITY €110
FIXED ASSETS €90
WORKING CAPITAL €50
IRS €30
PRE-TAX IC
EQUITY €40
IRS €20
FIXED ASSETS €90
WORKING CAPITAL €50
NET DEBT €80
EQUITY €30
IRS €30
PRE-TAX IC
Modigliani & Miller
VL = VU + PV(TS) – PV(CFD) +/- Agency
We hate Modigliani & Miller: Capital Structure can affect
Expected Cash Flows of the Assets Unlevered Risk Assets are Subject to
Governance Matters
Understand indirect costs of financial distress
FedEx early days: What would you do?
Monday: $27,000 bill due
Friday: $5,000 cash at hand
Of course, we would all do this!
“Gambling for resurrection” problems Loss of potential customers Loss of management efficiency/focus Restrictive contractual terms in day-to-day
operations Agency costs
Between shareholders and managers Between shareholders and debt-holders
Shareholders view equity as an option on the assets
Managers as empire-builders Private benefits of control