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Finance 2 Review

Section C, 2010

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Review Materials

Case and class notes Review problems (weekly) Quizzes (each module) Module Overviews (each module) Practice Exam (Nova Chemical) These slides

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Three Pillars of Fin 2

Technical proficiency Technical judgment Managerial judgment

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Three Pillars of Fin 2 Technical proficiency

– Ability to correctly apply finance tools, formulas, concepts, e.g.,» What is Free Cash Flow?

» What is CAPM rate of return given Rf, Beta, MRP?

– Review problems, quizzes Technical judgment

– Ability to decide on inputs or ranges for technical analysis, e.g.,» What is a reasonable LT growth rate?

» What how did MRP change during financial crisis?

– Needs supporting reasons and evidence Managerial judgment

– Ability to decide what a manager should do, e.g.,» High cost financing from Warren Buffett? (Fin 2, Day 1)

» Hostile tender offer for Genentech, at what price? (Fin 2, Day 27)

– No right answer, careful reasoning, weighing of pros and cons

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Technical Proficiency

Correctly construct models and apply analytic tools and concepts, given

appropriate inputs

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Technical Proficiency—ValuationYou should be able to …

Forecast Income Statement, Balance Sheet and Free Cash Flow outcomes based on assumed operating ratios

Calculate discount rates (and know when to use each one)– CAPM: Rf, Re, Ra, Rd, WACC

– Yield (or promised rate)

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Technical Proficiency—ValuationYou should be able to …

Calculate (and interpret) risk parameters– Beta of equity, Beta of assets, Beta of debt,– Volatility

Calculate Enterprise, Equity and Per Share Values– Using WACC or APV methods, as appropriate

Value Interest Tax Shields Value Synergies

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Technical Proficiency—Financial Policy — You should …

Know the rules of priority for debt– Tranches: senior, junior– Secured vs. unsecured– Rules of bankruptcy

Know the mechanics of dividend payments and stock repurchases– Announcement, ex-date, payment date

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Technical Proficiency—Financial Policy—You should …

Be able to assess the capital structure and liquidity of a company– Relative to competitors

– Relative to potential shocks, e.g., » increase in price of gold

– Relevant measures are» D/V [how much of enterprise market value is pledged to debt]

» Interest coverage, eg, EBIT/Int

» Cash/ST Financing [can company withstand a bank run?]

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Technical Proficiency—Derivatives—You should know how to …

Short sell stock Estimate the expected payoff from buying

insurance Analyze the payoff functions of

– Forward sales and purchases

– Simple options (puts and calls)

– Complex/composite options» Spread collars

» Local collars

Calculate exposure to margin calls

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Technical Proficiency—Derivatives—You should know how to …

Calculate the value of– Forwards

– Options (simple puts and calls)

– Composite positions» Floor

» Cap

» Spread collar

» Local collar

» Cash + collar

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Technical Proficiency—M&A—You should know how to …

Calculate properties of a stock-for-stock exchange– Exchange ratio

» Zero premium» Non-dilutive (to each side)

– % Ownership (both sides)– Acquisition Premium– Wealth Transfer– Downside Protection– Deal NPV

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Technical Judgment

Make and support reasoned technical assumptions when faced with an

ambiguous environment

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Technical Judgment—Law of One Price

Modigliani-Miller capital structure irrelevance

M-M dividend irrelevance Replication of option payoffs via

dynamically updated portfolio Covered interest parity

When must these LOOP relationships hold true?

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When do the LOOP relationships hold?

In a “perfect” market– No taxes– No transaction costs – No asymmetric information

In imperfect markets, get deviations from LOOP arbitrage opportunities for traders– As long as LOOP is eventually restored

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Technical Judgment—Valuation

Selection of comparable companies Selection of future operating ratios

– Revenue growth, cost, asset efficiency Tax rates

– Tax payer or not? (MCI)– Tax holiday (Geita mine in Ashanti)

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Technical Judgment—Negotiation

Reservation prices– Can be based on public information

– May change based on confidential, i.e. asymmetric information

ZOPA “Zone of positive agreement”– Range of values (or exchange ratios) between the

buyer’s and seller’s reservation prices

– Deals should fall within the ZOPA unless one or the other side (or both) receives new information

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Technical Judgment—Market Responses/Announcement Effects

New information causes a reassessment of value Market prices change as a result Announcement effects are large for

– New issues of equity (signals)

– Mergers (synergies)

– Anything reflecting on creditworthiness

Market is always second-guessing managers… get used to it!

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Technical Judgment—Fiduciary Responsibilities

Who has them?– Officers, director and controlling shareholders

What is required of fiduciaries?– Duties of care, loyalty, and transparency (LCA)

– Act in the best long-run interest of “corporation”

– If corporation will cease to exist in the short run, maximize value of shares

» Revlon duties apply to cash acquisitions only

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Managerial Judgment

Use technical proficiency and technical judgment to design an integrated set of actions to address the problem at hand

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Managerial Judgment—Financial Policy

How much debt can a company carry?– Short run? Long run?

When should a company issue equity (or not)? How should it finance a project or an acquisition? When should a company

– Pay regular dividends

– Pay a special dividend

– Repurchase shares

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Managerial Judgment—Value Creation

What is the value (NPV) of a capital project (like Ashanti’s Geita mine)?

What is the value of an enterprise– To a buyer in an auction (Berkshire-Carters)– To the seller in an auction (Burger King A)

Does the combination of A and B create value? How? (Cost savings, cross-selling, market power)– JPMC-Bear Stearns– BNY-Mellon– PepsiCo-Quaker– Wine Country combinations– Roche-Genentech– MCI with Verizon or Qwest

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Managerial Judgment—Risk Management

What risks should I insure (pay to avoid)– Systematic to me, unsystematic to others, eg, rainfall in India

What risks should I hedge (via derivatives)– Can be cheaper than purchasing insurance

– Introduces new risks, ie, basis risk and margin calls

What controls should I place on my traders/risk managers?– OSG currency hedging policy

– Ashanti hedgebook became a profit center and then blew up

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Managerial Judgment—Negotiations

In a two-way negotiation, what is my bargaining power?– Which end of the ZOPA should I aim for?

» BNY vs. Mellon –will BNY really walk from the deal?

» PepsiCo Round 1 vs. Round 2

» Roche-Genentech pre and post tender offer

What tactics will I use?– Headline vs. intrinsic value?

– First vs. final offer?

– Can I use price protection (floors, caps, collars) to make the deal more attractive to my counterparty?

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Managerial Judgment—Philosophy

In a three-way negotiation, am I willing to be the party “left out”? – Short-term Pstk increase vs. long-term performance (Wine Country)

When should I walk away from the table? – BNY, PepsiCo, Roche

When should I come back?– PepsiCo, Roche

Should I bailout a failing company?– JP Morgan-Bear Stearns

Should I use high-cost emergency financing to survive and live to play another day?– Williams/Buffett loan

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Managerial Judgment—Core Beliefs

Does my firm have a mission different from or in addition to shareholder value maximization?– Congressional Oversight Panel — mission to represent

the US public

– BASIX — mission to bring capital markets to rural India