FINANCE 541FINANCE 541
Cases in Managerial Finance
Today’s class...Today’s class...
Introductions and house keeping
Financial planning and analysis
Seminal ideas in corporate finance
My BackgroundMy Background
NAME: Ken Shah BORN: Bombay, India PhD: University of Oregon INDUSTRY EXPERIENCE:
– 4 yrs Floor Trader / Stock Broker - Bombay Stock Exchange
– 3 yrs Quantitaive Portfolio Management Research, Portland, Oregon
Academic ExperienceAcademic Experience
Taught at– University of Oregon– University of Auckland– Southern Methodist University
Courses in capital budgeting, corporate finance, investments, and money and banking
Recent ResearchRecent Research
Capital Structure– How do investors react to capital structure
changes? The nature of information conveyed by capital
structure changes, Journal of Financial Economics, 1994
Initial Public Offerings– Investigate/explain perfomance over the long
haul after going public The performance of firms that go public, Journal of
Financial Economics, 1996
Current ResearchCurrent Research
What is analyst forecast precision around large changes in earnings– Are the forecast errors related to firm
characteristics? Is there a book-to-market effect in bond
returns?– Investigate risk vs. expectation bias hypotheses
Please Introducduce Please Introducduce yourself...yourself...
Please fill out the student information sheet
Drop by my office!
Name cards
Course ObjectivesCourse 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 PrerequisitesCourse Prerequisites
Willingness to learn & work hard! Understanding of:
– Financial statements– Rudimentary statistics– Spreadsheets– Fundamentals corporate finance
Valuation, M&M propositions, agency theory
Recommended: FINC 515
Anticipate...Anticipate...
About 6 - 8 hours of work outside of class
Frustrations with unstructured problem solving!
Frustrations with computer work!
TextsTexts
Required: – Kester et al., Case Problems in Finance– Packet of Readings
Optional: – Brealey & Myers, Principles of Corporate
Finance– Higgins, Analysis for Financial Management
EvaluationEvaluation
Group Case Presentation 250 Exec. Summaries/Participation 250 Midterm Case 250 Final Case 250
TOTAL 1000
Case PresentationsCase Presentations
In groups of 4 - 5 students 50 - 60 minutes in length Formal write up Field questions (20 minutes)
ParticipationParticipation For those not formally presenting Every group must have analytical solution to
every case brought to class The case questions in bold are to be addressed Randomly chosen group will be asked to provide
alternative solutions Solution will count towards participation grade Demonstrate preparedness
Midterm & FinalMidterm & Final
Formal 5 page case evaluation
Take home
One week to complete
Individual effort
ReadingsReadings
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 DesignCourse Design
Growing Pains - Private enterprise
Midlife crisis - Managing growth
Over the hill - Restructurings
Case ProgressionCase Progression Managing Growth / Private enterprise:
– Short term financing / Managing growth– Going public
Sustaining Growth / Financing Policy:– Corporate disbursement policy– Capital structure policy & WACC
Lower Growth / Corporate Reorganizations:– Takeovers– LBOs– Bankruptcy
Cases...Cases...
Are deliberately vague!
Have information deliberately presented in random order - not in the order of importance
Offer little guidance on method of solution
My approach to a case...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...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...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...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...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 judgment, 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!
Learning from case methodLearning 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 PlanningFinancial 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 Elements of Financial PlanningPlanning
Forecasting– Pro-forma statements
Finding the optimal financial plan
Watching the plan unfold
Analyzing performanceAnalyzing performance
Financial ratios
Beware of accounting definitions
Choosing a benchmark– trend over time– industry counterparts (Dept. of Commerce, Dun
& Bradstreet, Robert Morris Assoc.)
Analytical ToolsAnalytical Tools
Sensitivity (what-if) analysis
Scenario analysis
Monte Carlo simulation
Decision Trees
Sensitivity AnalysisSensitivity 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 AnalysisScenario 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 SimulationsMonte 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 TreesDecision 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?Is theory a dirty word?
Theory is simply an exercise in ridding distractions
It can aid to clarify thinking
Theory for its own sake serves no useful purpose in this class
Bridging Finance Theory and Bridging Finance Theory and Managerial Finance...Managerial Finance...
CAPM– NPV, capital budgeting, WACC
Modigliani-Miller Propositions– Dividends, capital structure, WACC
Agency Theory– Corporate governance, compensation
Option Pricing– Risk management, real options in capital
budgeting Asymetric Information Models
CAPMCAPM
Widely used in NPV, capital budgeting Efficient Portfolios, CML, SML Recently under attack (is beta dead?)
Rivals: APT, Empirical Multifactor Models
M-M PropositionsM-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 & Corporate TaxesM-M & Corporate Taxes
Firm Value = value if all equity financed
+ PV(tax shield)
Tax shields increase with the proportion of debt in the capital structure
All debt firm? absurd
M-M: Add personal taxesM-M: Add personal taxes
Tax gain at corporate level offset by tax at personal level
Post-TRA 1995 tax rates favor debt
Irrelevance again if :
(1-Tp) = (1-Tg) * (1-Tc)
Bankruptcy CostsBankruptcy Costs
Higher levels of debt involve– Direct bankruptcy costs– Indirect bankruptcy costs
These serve to offset the tax advantage of debt
Bankruptcy and liquidation are separate issues!!
Bankruptcy CostsBankruptcy Costs
Direct costs estimates
3% of book assets
20% of market equity
Quite substantial!
Agency CostsAgency Costs
Conflicts are inherent between– Share holder - Management– Share holder - Bond holder
Firm value is reduced by– Excessive perk consumption– Take unwarrented risk– Undergo profitable investments
with debt
Agency Cost ModelsAgency Cost Models
Used successfully in explaining
– LBOs, Takeover, restructuring activity– Debt covenants– Design of board of directors– Design of incentive compensation
Asymmetric Information Asymmetric Information ModelsModels
Presupposes management have superior information about own firm value
Changes in dividends, capital structure convey information to investors about firm value
Do managers deliberately signal?
Optimal Capital StructureOptimal Capital Structure
Maximising firm value involves balancing
– Tax benefits of debt– Bankruptcy costs– Agency costs of debt– Agency costs of equity– Information signalling costs
Option Pricing ModelsOption 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 ModelsOption Pricing Models
Binomial– When outcomes at each node are limited in
number
Black - Scholes (& variants)– For continuous range of outcomes such as
market prices
Working Capital IssuesWorking Capital Issues
How much cash should a company hold?
What collections and payment policies should a company follow?
What is the optimal level of inventory?
Working capital MgmtWorking capital Mgmt
Common sense rather than theory guides the issue
Trial and error!!
There is some effort to apply economic principles to account receivables management and trade credit(see readings)
Short term Fin’l PlanningShort term Fin’l Planning
Requires forecast of cash requirements Method of raising required cash; consider
explicit and implicit costs Monitoring cash inflows and outflows, debt
covenants Taking corrective steps as necessary
ST vs. LT sources of fundsST vs. LT sources of funds
Again, no clear theory to guide us
Attempt is usually made to match duration of assets and liablities similar to banks
Firms can be conservative (using LT sources) or aggressive (using ST sources)