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 detailscbellon@faculty.ie.eduCell: +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