FINANCE 580

Cases in Managerial Finance

Today’s class...

• Introductions and house keeping

• Financial planning and analysis

• Seminal ideas in corporate finance

My Background

• NAME: Ken Shah• BORN: Bombay, India• PhD: University of Oregon• INDUSTRY EXPERIENCE:

– 4 yrs Floor Trader / Stock Broker - Bombay Stock Exchange

– 3 yrs Quantitative Portfolio Management Research, Portland, Oregon

Academic Experience

• Taught at– University of Oregon– University of Auckland– Southern Methodist University

• Courses in capital budgeting, corporate finance, investments, and money and banking

Recent Research• Analyst Forecasts

• Bond Returns

• M&A Fairness Opinions

• Capital Structure

• Initial Public Offerings

Course Objectives• Expose you to anticipated managerial decisions in

finance

• Inculcate financial way of thinking

• Bridge theory and practice

• Increase proportion of good financial decisions to bad ones!!

Course Prerequisites

• Willingness to learn & work hard!• Understanding of:

– Financial statements– Rudimentary statistics– Spreadsheets– Fundamentals corporate finance

• Valuation, M&M propositions, agency theory

• Pre-requisite: FINC 515

Anticipate...

• About 5 hours of work outside of classper week

• Frustrations with unstructured problem solving!

• Frustrations with computer work!

Texts

• Required: – Bruner, Case Studies in Finance (online – no

physical text)– Packet of Readings – at Copymart

• Optional: – Brealey & Myers, Principles of Corporate Finance– Higgins, Analysis for Financial Management

Evaluation

• Group Case Presentation 300• Participation 100• Midterm Case 300*• Final Case 300*• TOTAL 1000

• * Please correct the syllabus

Grading Policy

• If you attend all classes and diligently complete all required work, you would be assured of a B- grade

• In order to get an A/A-, you must show work of superior quality and make a meaningful contribution to the class discussions– roughly top 15% of the class

Class Attendance

• Mandatory– Discussion particularly important in a case class

• Please inform me of anticipated absences– More than 1 absence will adversely affect your grade

• Please include in email subject “FINC 580 F06”– Please send an introductory email and feel free to

tell me about yourself, and any concerns/absences you anticipate

Case Presentations

• About 30-40 minutes in length

• Formal write-up & Class Handout

• Field questions

Non-presenting students

• Demonstrate preparedness

• Come to class with analytical solution– E.g. see Gulf Oil solution

• No formal write-up

Midterm & Final

• Formal 3 page case analytical solution

• Take home

• One week to complete

• Individual effort

Readings

• Required: – Please be prepared to discuss them in class

• Background:– To expose you to practice, analysis, and theory in

the case subjects– Necessary but not explicitly discussed

Course Design

Growing Pains - Private enterprise

Midlife crisis - Managing growth

Over the hill - Restructurings

Case Progression• Managing Growth / Private enterprise:

– Short term financing / Managing growth– Going public– WACC

• Sustaining Growth / Financing Policy:– Payout policy– Capital structure policy

• Lower Growth / Corporate Reorganizations:– Takeovers– LBOs– Bankruptcy

Cases...

• Are deliberately vague!

• Have information deliberately presented in random order - not in the order of importance

• Offer little guidance on method of solution

Case Solution Strategy

• Reading the case– First time just read it like a magazine article – look at

forest, not the trees– Leaf through the exhibits– Go back and read it more thoroughly taking notes

Develop your awareness

• Who are the decision makers and what pressures do they face?

• What is the business of the company?• What are the goals of the firm?• How well has the firm performed in its pursuit of

the goals?

Defining the problem

• Common trap – symptom not the real problem

• Believability of key assumptions

• Assumptions drive results

Analysis

• Run the numbers and go to the heart of the matter

• Perform analysis on key assumptions• Get down to the key bets• Get to business issues quickly

Recommendation

• Prepare to participate: take a stand• In Class: Participate actively in support of your

conclusions but be open to new insights as they emerge

• Trust the process:– Case learning is cumulative over time

My approach to a case...

• Read it twice, ignore numbers• List all issues• Rank issues in order of importance• Articulate the central issue• Identify relevant theory and evidence• Formulate assumptions for analysis• Perform data analysis• Recommend a course of action

Repeat

Analyzing a case...• At first, see the forest, not the trees

• Analyzing numbers is necessary but NOT an end in itself– it is presumed that you know how to analyze

numbers

• Put yourself in the shoes of the decision maker

Analyzing a case...

• Identify the decision makers and their pressures and stakes in the situation

• Thoroughly understand the nature of the business, product, firm’s competence, competitors, structure of the industry etc.

• What are firms goals? How well has it pursued them?– DuPont, ratio analysis, growth rates, measures of value

creation

Analyzing a case...

• Is the problem at hand a symptom of a larger problem?– E.g. a lender is often asked to provide cash to tide

over shortfall.

• Study may reveal that it’s really the product obsolescence, unexpected competition etc.

Analyzing a case...• An executive rarely thinks of a problem as an

exercise in forecasting techniques or discounting method

• But rather, thinks of it as a problem of judgement, deciding on which people, concepts or environmental conditions to bet.

• Get the #’s right - but go further!!• Prepare to take a stand - and defend it!

Case Write-up

• Do NOT simply regurgitate the information in the case in your introduction to the case

• Distill and analyze the information and present it only if you believe it has an impact on your analysis and solution

Learning from case method• It’s not passive - the more you participate and

think, the more you learn

• It’s cumulative - should not measure the success of your progress on the basis of any single case discussion– You will arrive at a better understanding over time,

after many cases - sometimes after the course is over!

Financial Planning

• Analyze financing and investment decisions

• Project future consequences of present decisions

• Decide on which alternative to undertake

• Measure subsequent performance against goals

Elements of Financial Planning

• Forecasting– Pro-forma statements

• Finding the optimal financial plan– Analysis

• Watching the plan unfold

Analyzing performance

• Financial ratios

• Beware of accounting definitions

• Choosing a benchmark– trend over time– industry counterparts (Dept. of Commerce, Dun &

Bradstreet, Robert Morris Assoc.)

Analytical Tools• Sensitivity (what-if) analysis

• Scenario analysis

• Monte Carlo simulation

• Decision Trees

Sensitivity Analysis

• Analyze the impact of changing a single variable one at a time– e.g. Formulate “Optimistic”, “Pessimistic”, “Expected”

cases• Identifies key variables• Ignores interrelations among variables

Scenario Analysis

• Consider alternative plausible combinations of variables

• Account for interrelations among variables– e.g. rise in oil prices -> increase scooter sales AND

increase costs• Overcomes limitations of sensitivity analysis

Monte Carlo Simulations• Model the strategy• Identify key variables• Draw from probability distributions of key

variables• Calculate results of strategy• Do that many, many times (computer)• Get distribution of outcomes• Range of answers - difficult to reconcile

Decision Trees

• Used for sequential decisions• Evaluate decisions at each node starting

backwards (reverse iteration)• Compute expected value

• Trees can quickly become complex• Incorrect handling of risk (discount rate)

Is theory a dirty word?

• Theory is simply an exercise in ridding distractions

• It can aid to clarify thinking • However, theory for its own sake serves no

useful purpose• Theory does provide a framework to start the

analysis

Caution…

• Do not try to force a solution to fit the theory

• Real world problems cannot conform to theory precisely

• Common techniques and theory’s guidance must be adapted to suit the problem at hand

• Do not take ‘cookie cutter’ approach!

Bridging Finance Theory and Managerial Finance...

• CAPM– NPV, capital budgeting, WACC

• Modigliani-Miller Propositions– Dividends, capital structure, WACC

• Agency Theory– Corporate governance, compensation, optimal contracts

• Asymmetric Information Models– Signalling, stock price reactions

• Option Pricing– Risk management, real options in capital budgeting

CAPM

• Widely used in NPV, capital budgeting• Efficient Portfolios, CML, SML• Recently under attack (is beta dead?)

• Rivals: – APT– Empirical Multifactor Models

• Book-to-market and Size effects

M-M Propositions

• Proposition I: Firm cannot change its total value by splitting cash flow into different streams (ie shareholders, debtholders)

• Proposition II: Expected return on common stock increases in proportion to its market debt to equity ratio

M-M Propsitions

• Many of the ‘perfect market’ assumptions have been relaxed without affecting core conclusions

• Teach us that it is important to focus on the business, not finance, if an enterprise is to be successful

Agency Theory

• Inability to write perfect contracts between principal and agent that ensures agent acts in the best interest of the principal

• Agency problem arises from delegation of decision making and imperfect information and imperfect monitoring

Agency Costs

• Conflicts are inherent between– Shareholder - Management– Shareholder - Bondholder

• Firm value is reduced by– Excessive perk consumption– Taking unwarranted risk– Forgoing profitable investments with debt

Agency Cost Models

• Used successfully in explaining

– LBOs, Takeovers, restructuring activity– Debt covenants– Design of board of directors– Design of incentive compensation– Use of convertible securities

Asymmetric Information Models

• Actions taken by better informed agents convey information to those less informed

• Management have superior information about own firm value

• Successful in explaining stock price reactions to announcements of corporate actions

• Do managers deliberately signal?

Option Pricing Models• The most successful pricing models in finance

• Used to value complex securities– convertibles, callables, warrants

• Adjustments to NPV in sequential decisions– Real options in capital budgeting

• Value incentive compensation– ESOPs

Option Pricing Models

• Binomial– When outcomes at each node are discreet and

limited in number

• Black - Scholes– For continuous range of outcomes such as market

prices

Finance in International context

• Basic finance theory is universal• Two additional issues arise:

– Exchange rates (PPP, IRP)– The extent to which global financial markets are

integrated:• Affects risk and discount rate

Gulf Corp Takeover

• An example of case ‘solving’, and my approach• An example of 1-page analytical solution

– Getting to the heart of the problem– Running numbers– Drawing conclusions