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)