f331: applied accelerated corporate finance

F331: Applied Accelerated

Corporate Finance

Ilya Strebulaev Stanford GSB Spring 2011

Course Syllabus

Aims and Objectives

The main aim of this course is to enable you to apply the fundamental ideas of financial

economics to the problems in the area of corporate finance with all the complexities the real

world entails. The main focus of this course is on the corporate financial manager and how

he/she reaches decisions as to capital investments, dividends, and financing of all sorts. We

will cover many issues that are important to a modern financial manager including such topics

as international corporate finance, managing high growth, leveraged buyouts, hostile takeovers,

private equity financing and venture capital, and financial distress.

Through cases and discussions of topical issues, the course will give you the opportunity

to analyze practical financial situations and problems, on the assumption that you are already

familiar with basic concepts from the core course (valuation, CAPM, capital structure, option

pricing). The course is thus applied, but within a rigorous theoretical framework.

The cases will be used to motivate our discussion of how to bridge the gap between

rigorous finance theory and its application to practical problems in corporate finance. The

cases and our discussion will embrace both “the big picture” and rigorous financial analysis.

Format and Teaching Methods

Each session we will generally spend our time both on a case and on a discussion of finance

theory and its applications. The discussion will usually focus on the application of theory to

real-life complex situations. The cases will offer the opportunity to apply and master the quan-

titative skills in such topics as valuation and financing decisions. The stress in the discussion

will be on qualitative issues and applications.

All students are expected to participate in the discussion and students will be frequently

(cold) called upon to illuminate their view on the topic, both theoretical underpinnings and

application.

Strebulaev F331: AA Corporate Finance

Students Responsibilities

The course is intensive and will require students to carefully prepare all cases, read and

understand a lot of materials, most of which are included in the course folder, and participate

actively in class discussion. Constructive class participation constitutes a significant portion

of the grade. Readings are important to understand applications and follow the lectures and

class discussions. The class is demanding: On average, students in past years spent between

5 and 10 hours per week on the course, in addition to attending classes.

As this course builds on prior sessions and is case oriented, regular class attendance is

essential. You should expect intensive and demanding cold calling. You should come with a

complete solution for each case and be ready to answer any questions related to the case and the

solution. Should a student be required to be absent, notification of professor by e-mail would

be appreciated. If you are not prepared for a given day, you should still attend. Your class

participation grade will suffer for the day but not as much as if I cold call you and discover that

you did not prepare. More than two absences during the quarter will have an adverse effect

on your grade, even if excused. If you show up late for class, it will be counted towards two

absences unless you inform professor in advance.

Both home assignments (Airbus and RJR Nabisco) should be done in groups of students’

choice, between 1 and 6 people. Only one report from each group should be submitted before

the start of the class on the day the assignment is due. The names of group members should be

stated clearly on the first page. Each report should be printed and contain at most 8 standard

pages, with standard margins and at least 11pt font.

You should treat class as you would a professional meeting. Be on time. Tardiness of

more than a minute is treated as an absence for the entire class unless you inform me in

advance. Do not read extraneous material. Do not engage in side conversations. Put all cell

phones/PDAs into silent mode. Laptops and PDAs could be used during class only to help

with case discussions.

Final Grade Break-downClass participation 20%

Turn-in assignments 15%

Mid term exam 30%

Final exam 35%


Readings

There will be a number of readings that students are expected to read before class. These

readings are marked with F. The recommended textbook is: Berk and DeMarzo, Corporate

Finance, 2nd ed., Prentice Hall, 2011. Other readings are included that are relevant and useful

for the discussed topic but are not necessary to read before class. Some of these readings are

at a more advanced level, and these are marked with } sign. Relevant financial information on

cases requiring financial analysis will be made available in spreadsheet format on Coursework.

Contacts

Instructor: Ilya Strebulaev. Office: Littlefield L313, phone: 725-8239

e-mail: [email protected]

Office hours: (Almost) any time if by prior arrangement.

Assistant: Sandra Berg. Office: L318, phone: 723-4494

e-mail: berg [email protected]


Important Dates

Tuesday April 12

Group assignment to be turned in: Airbus

Wednesday April 27

Mid term examination

Tuesday May 17

Group assignment to be turned in: RJR Nabisco.

Friday June 3– Saturday June 4

Take home final examination


Computer Worksheets for Cases

Financial information for a number of the cases used in this course is available for use with

Excel. This allows you to make numerical and graphical analyses without having to enter the

income statement, balance sheet and certain other data yourself.

Most of the numerical data found in the case exhibits is in the spreadsheets. However, not

all such data are provided. The following is a list of the cases which will be made available on

Coursework in the folder “Excel Files”:

CASE NAME FILE NAME

Arundel Partners ARUNDEL

Polaroid Corporation POLAROID

New Raggedly Bear Company NEWRAGGEDLY

Iridium PLC IRIDIUM

Delphi DELPHI

Palamon Capital Partners PALAMON

Red October, The Hostile Bid for REDOCT

RJR Nabisco RJRNABISCO


Summary of Class Schedule

Session Case Lecture/Discussion

1 Case of the Unidentified Industries Course introduction

2 Shurgard Financing international expansion

3 Kendle International, Inc. Managing growth

4 Airbus Capital budgeting

5 Arundel Partners Real options

6 Capital structure

7 Debt Policy at UST, Inc. Leveraged recap, long-term financing

8 Polaroid Corporation Financial flexibility

9 Risk management, international finance

10 New Raggedly Bear Company Financial ratios and short-term financing

11 Iridium LLC Financial distress

12 UAL The bankruptcy process

13 Delphi Distressed restructuring

14 RJR Nabisco Leveraged buyouts

15 RightNow Technologies Venture capital

16 Palamon Capital Partners Private equity / growth equity

17 The Hostile Bid for Red October Mergers & Acquisitions

18 Review and synthesis of the course


Session 1Introduction to the Course

Principles of Valuation

Day: March 31 (Thursday)

Preparation for class

Refresh your core finance course notes.

Read all required materials.

Prepare the case of the Unidentified Industries.

Case

• The Case of the Unidentified Industries. (Read the case and come prepared to

discuss the questions; no write-up required)

1. For each of the 11 sets of financial data, identify the industry represented.

2. Be prepared to explain the distinctive financial characteristics associated with each

industry.

Topic of lecture and discussion

The world of the modern financial manager

Valuation:

• Value creation and destruction: NPV, IRR.

• Multiple valuation

• Free Cash Flows

• Weighted Average Cost of Capital (WACC)


Readings for class

Introduction

F Graham, John R., and Campbell Harvey, “How Do CFOs Make Capital Budgeting and

Capital Structure Decisions?”, Journal of Applied Corporate Finance, 2002, 15, Number

1, 8–23.

} Kaplan, S. and Ruback, R., ”The Market Pricing of Cash Flow Forecasts: Discounted

Cash Flow vs. the Method of ’Comparables’,” Journal of Applied Corporate Finance,

Winter 1996, pp. 45-60.

} Arbar, El, and G. Bennett Stewart III, “The EVA Revolution”, Journal of Applied Cor-

porate Finance, 1999, 12, Number 2, 18–31.

} Graham, John R., and Campbell Harvey, 2001, “The Theory and Practice of Corporate

Finance: Evidence from the Field”, Journal of Financial Economics, 60, 187–243.

Valuation and the Cost of Capital

F Berk-DeMarzo, Ch. 6 (skim), 7, 9.3, 18,1–18.2

F Pettit, Justin, “Corporate Capital Costs: A Practitioner’s Guide”, Journal of Applied

Corporate Finance, 1999, 12, 1, 113–120.

} Cornell, B., J. I. Hirshleifer, and E. P. James, “Estimating the Cost of Equity Capital”,

Contemporary Finance Digest.

} Cooper, Ian, and Kjell Nyborg, “Discount Rates and Tax: A Teaching Note”, London

Business School.

} Bruner, R. F., K. M. Eades, R.S. Harris and R. C. Higgins, “Best Practice in Estimating

the Cost of Capital”, Financial Practice and Education, Spring/Summer 1998.


Session 2Financing International Expansion

Day: April 5 (Tuesday)

Case

Shurgard Self-Storage.

1. What is your assessment of Shurgard and the self-storage business?

2. How has Shurgard performed in Europe to date? Will self-storage turn out to be a

successful business in Europe?

3. What is your view of the firm’s expansion plans in Europe? Is it realistic to plan for 133

to 170 stores by 2003? What challenges/opportunities will Shurgard’s management face?

4. The consortium is proposing to invest EUR122 million of equity by 2003 in return for

43.3% ownership. Is this a fair valuation? A detailed valuation of this real estate business

is quite complicated, but one way to get a rough estimate is to follow the two steps below:

(a) Exhibit 3 provides a pro forma income statement for the “minimum” plan of opening

133 stores by 2003. Assuming no new stores were built after 2003 and assuming these

stores reach steady state profits in the next year or two, what would the consolidated

EBITDA be for Europe? In answering this questions, use the following mature store

operating margins (in %):

Belgium Sweden UK France Netherlands

Year 2 (2000) 40.6 46.6 47.8 47.0 39.7

Year 3 (2001) 66.3 63.6 70.6 64.7 69.3

Year 4 (2002) 66.6 63.9 70.8 65.0 69.6

Year 5 (2003) 66.8 64.2 71.0 65.3 69.8

(b) Under these assumptions, what is a reasonable value for Shurgard Europe? Is 43.3%

ownership reasonable for the consortium?

5. Review the terms and conditions, such as board membership, proposed by the consortium?

Are these reasonable from the perspective of Shurgard?

6. Would you advise Shurgard to go ahead with the expansion plan and proposed financing?



• International Expansion

• External financing

• M&A


Session 3Managing Growth

Day: April 7 (Thursday)

Case

Kendle International, Inc.

1. How does the CRO business work? How is Kendle doing?

2. What strategic choices does Kendle face? Can it survive as a privately owned domestic

company or does it need to become a much bigger firm with operations outside the US?

3. Should Candace Kendle and Christopher Bergen sell their firm to another company in

early 1997? How does the potential sales price of the firm compare to its underlying value

as a stand-alone firm, using a discounted cash flow (DCF) analysis?

4. Do the acquisitions of U-Gene and gmi make sense? Are the proposed deals priced fairly?

5. What strategy would you recommend: Proceed with both acquisitions now or do one

followed by an initial public offering (IPO) and the second acquisition later?


Managing growth. Harvest options.


Session 4Capital Budgeting


Group assignment to be turned in: Airbus A3XX: Building the

World’s Largest Commercial Jet

1. Why is Airbus interested in building the A3XX? What are its objectives?

2. How many aircraft does Airbus need to sell in order to break even on the investment? Is

this number greater or smaller than your estimate of total demand for very large aircraft

(VLA) over the next 20 years

Hint: Consider all capital providers as a single entity and calculate the break-even return

to them collectively. To calculate the break-even number of planes, calculate the present

value of the required investment and compare it to the present value of a growing per-

petuity of cash flow from planes sales beginning in 2008. Please assume an equity risk

premium of 6% in your analysis.

3. As Boeing, how would you respond to this situation? How does your answer depend on

what you think Airbus is likely to do?

4. Should Airbus commit to building the A3XX? How many orders should Airbus have

before committing to develop the plane?

NOTE: Submit one report per group of students (between 1 and 5 people), to be handed in

before the start of class. State the names of group’s members clearly on the first page. Each

report should be printed and contain at most 8 standard, single-sided pages, with standard

margins and at least 11pt font.


Capital budgeting

Readings for class

F Berk & DeMarzo, Ch. 7–9.


Session 5Real Options


Case

Arundel Partners.

1. Why do the principals of Arundel Partners think they can make profits buying movie

sequel rights?

2. Comment on the proposed deal structure. For instance, why do they want to buy a

portfolio of rights in advance rather than negotiating film-by-film? Does it make any

difference to the value of the options if Arundel buys options from just one studio or from

several? Would it make any difference to their value if Arundel were a large corporation

rather than a small partnership?

3. Estimate the per-film value of a portfolio of sequel rights using several approaches, spec-

ifying the assumptions underlying each of them. Assume throughout that the nominal

risk-free rate is 6% per annum.

(a) First, simply compute the value the portfolio (i.e., at the time Arundel pays for the

rights) using the traditional NPV approach, ignoring embedded options. Based on

this method, how much should Arundel be willing to pay per sequel right?

(b) Second, modify the NPV approach to try and account for the embedded option(s),

explaining the nature of the option(s) you focus on. What is the implied value per

right?

(c) Third, use the Black-Scholes model, thinking carefully about the inputs. What is

the implied value per right?

4. Is the selling of packages of sequel rights a good way to finance film production? What

are in your view its main pros and cons? What problems or disagreements would you

expect Arundel and a major studio to encounter? What contractual terms and provisions

would you suggest Arundel insist upon?


Real options.


Readings for class

F Berk & DeMarzo, Ch. 22.

} Luerhman, T. A., “Investment Opportunities as Real Options: Getting Started on the

Numbers”, Harvard Business Review, July/Aug 1998, 51–67.


Session 6Capital Structure


Case

There is no case to prepare for this session (Relax!). We will be discussing a number of examples

during the class. The case for next class (Debt policy at UST) and other cases in the following

classes use many of the concepts we will be discussing today.


Capital Structure.

Raising external financing. IPOs, SEOs, 144a.

Bank vs public debt. Short-term vs long-term debt.

Credit lines, commercial paper, and cash management.

Static trade-off and pecking order explanations of capital structure.

Financial innovations and their effects on capital structure.

Readings for class 6 and 7

F Berk & DeMarzo, Ch. 14 (skim), Ch. 15.5, 16.4–16.8

F Carow, K. A., “A Survey of US Corporate Financing Innovations: 1970–1997”, Journal

of Applied Corporate Finance, 2003, 111-119.

} Patrick, Steven C., “The Balanced Capital Structure”, Journal of Applied Corporate

Finance, 1998, Number 1, 111-119.

} Heine, Roger, and Frederic Harbus, “Towards a More Complete Model of Optimal Capital

Structure”, Journal of Applied Corporate Finance, 2002, 15, Number 1, 33–45.


Session 7Long-term financing


Case

Debt Policy at UST Inc.

Your job is to analyze the effect of leverage on UST, and to propose a recapitalization plan

(or not). Throughout, ignore the effect of personal taxes.

1. Describe briefly UST’s business, putting particular emphasis on the potential sources of

risk, and your evaluation thereof. How well is UST doing?

2. Describe briefly UST’s current capital structure. In your view, is it a good capital struc-

ture for UST? If yes, what are its main benefits? If not, what might explain why UST

has such a capital structure?

3. From the standpoint of credit analysts and potential bondholders, what are factors of

importance when analyzing UST? What credit rating would you assign for a moderate

addition of debt? NOTE: Total interest expense on existing debt is $7.3 million.

4. Analyze the effects of $0.5 billion and $1.0 billion in new debt and concurrent share

repurchase (and subtraction of equity). What happens to Earnings per share (EPS) in

case of addition to debt? Why? Which leverage ratio maximizes EPS?

5. Decision time: Summarize the likely costs and benefits of leveraging UST. Articulate

and defend an ”optimal” capital structure for UST. Should UST undertake a major

recapitalization of the company?


Optimal capital structure and financial flexibility.

Readings for class

See previous session and

F Berk & DeMarzo, Ch. 15.1–15.3


Session 8Financial Flexibility


Case

Polaroid Corporation.

1. What are the main objectives of the debt policy that Ralph Norwood must recommend

to Polaroid’s board of directors?

2. What financing requirements do you foresee for the firm in the coming years? What

are the risks associated with Polaroid’s business and strategy? In your view, what are

Polaroid’s peer firms?

3. Drawing on the financial ratios in case Exhibit 9, how much debt could Polaroid borrow at

each rating level? What EBIT coverage ratios would result from the borrowings implied

by each rating category?

4. Using Hudson Guaranty’s estimates of the costs of debt and equity in case Exhibit 11,

which rating category has the lowest overall cost of funds? Do you agree with Hudson

Guaranty’s view that equity investors are indifferent to the increases in financial risk

across the investment grade debt categories?

5. Is Polaroid’s current maturity structure of debt appropriate?

6. What should Ralph Norwood recommend regarding:

• The target bond rating;

• The level of flexibility of reserves;

• The mix of debt and equity;

• The maturity structure of debt;

• And any other issues you believe should be brought to the attention of the CEO and

board?



Optimal capital structure and financial flexibility, the role of “slack”.

Financial ratios and short-term financing, cash management.

Readings for class

} Barclay, Michael J., and Clifford W. Smith, “On Financial Architecture: Leverage, Ma-

turity, and Priority,” Journal of Applied Corporate Finance, winter, 1996, 4–17.


Session 9Corporate Finance Theory and Applications


Case

We will be discussing a number of examples during the class. There is no case to prepare for

this session (relax after your mid-term!!)


Corporate finance: most important ideas

Perfect and imperfect markets

Agency costs: adverse selection, moral hazard

Agency costs: managers/equityholders, equityholders/debtholders, internal/external financing

Executive compensation

Applications to the current financial crisis

Readings for class

• Relax!

• Come prepared to digest new ideas.


Session 10Financial Ratios and Short-Term Financing

Day: May 3 (Tuesday)

Case

New Raggedly Bear Company.

1. What does an analysis of the company’s financial ratios tell you?

2. If sales are $38.4 million in 2008, what will be company’s funds needs?

3. Will the additional bank loan solve the company’s problems? Is it appropriate? What is

appropriate?


Short-term financing and financial ratios analysis.

Readings for class

F Berk & DeMarzo, Ch. 26, 27 & Ch. 19, pp. 629–636.


Session 11Financial Distress

Day: May 5 (Thursday)

Case

Iridium LLC.

Your team of experts has been brought in to do a post-mortem on the Iridium experience.

Prepare a discussion to address the following questions.

1. Describe briefly Iridium’s financial strategy. (No need to assess it at this point). How did

Iridium justify its target debt-to-total book capitalization ratio of 60%?

2. Assess Iridium’s financial strategy. In your view, did it have the wrong target capital

structure, issue the wrong kind of capital, or issue capital in the wrong sequence?

3. Based on DCF analysis and using the forecast in Exhibit 5, determine Iridium’s enterprise

value, equity value and per share value. What are the important determinants of your

DCF valuation of Iridium? How confident are you in your valuation?

4. What were the major factors that caused Iridium to fail?

5. What lessons for the financing of large green field projects do you draw from Iridium’s

experience?

NOTE: There is a typo in Exhibit 5: in 2000 Total Debt should be 3,437 not 4,437.


Financial distress. Corporate default, bankruptcy, reorganization.

Readings for class

F Berk & DeMarzo, Ch. 16.1–16.3


Session 12The Bankruptcy Process


Case

UAL: Pulling out of Bankruptcy in 2004.

1. Why did UAL file for bankruptcy protection in December 2002?

2. What is the rationale for allowing companies to restructure their debts and operations

under Chapter 11 bankruptcy protection?

• What is the role of the automatic stay, which prevents creditors from pursuing their

claims to a defaulted borrowers assets outside of bankruptcy court?

• Why do we allow debtor-in-possession financing for companies operating under

Chapter 11 protection? Why are DIP loans granted seniority to firms pre-petition

obligations?

3. What are the incentives of the different parties involved in restructuring UAL? What are

the incentives of the firms management? Secured creditors? DIP lenders? Unsecured

creditors? Employees?

4. What are the important costs of financial distress that UAL is facing? How would these

costs of financial distress vary across different industries?

5. Why has leverage in the airline industry been high relative to other industries?

6. As UAL, would you continue making required contributions to your pension plans?


Corporate default and the bankruptcy process.


Readings for class

F Gilson, Stuart, “Managing Default: Some Evidence on How Firms Choose Between Work-

outs and Chapter 11”, Journal of Applied Corporate Finance, 1991, 4(2), 62–70.

} Weiss, Lawrence, “The Bankruptcy Code and Violations of Absolute Priority”, Journal

of Applied Corporate Finance, 1991, 4(2), 71–78.

} McConnell, John, and Henri Servaes, “The Economics of Prepackaged Bankruptcy”, Jour-

nal of Applied Corporate Finance, 1991, 4(2), 93–97.


Session 13Distressed Restructuring


Case

Restructuring at Delphi Corporation.

1. What key challenges does Delphi management need to address in the reorganization?

2. If you were advising Delphi management during its negotiations with GM and the UAW,

what would you have considered your primary bargaining strengths or weaknesses in

dealing with each party?

3. How well did the UAW fare in its negotiations with Delphi and GM?

4. How well did GM fare in its negotiations with Delphi? What justification is there for

giving GM a $2.7 billion unsecured claim?

5. How well do the Appaloosa investors fare under the reorganization plan? Did Appaloosa’s

involvement help or hinder the reorganization process?

6. In your judgment, is the plan of reorganization a good plan? How do you think the

different classes of claimholders will vote?


Corporate default and the bankruptcy process.

Readings for class

See previous session.


Session 14Leveraged Buyouts


Group assignment to be turned in: RJR Nabisco

1. What was the value of RJR Nabisco under

(a) The pre-bid operating strategy?

(b) The Management Group’s operating strategy?

(c) KKR’s operating strategy?

2. What accounts for any difference in the value of the three operating plans?

3. Evaluate the Special Committee’s use of an auction of RJR Nabisco.

4. Which bid should the Special Committee select, if any? What other actions should the

Special Committee take?


Leveraged buyouts. Management buyouts.

Readings for class

F Berk & DeMarzo, Ch. 28, 18.3


Session 15Venture Capital


Case

RightNow Technologies.

1. Evaluate the progress of the company and its situation at year end, 2003.

2. Based upon the data in the case, what is a fair value for RightNow? If the company hits

its forecasts, what could the company be worth in the future?

3. As Gianforte, what is the lowest price you would sell at? As the venture capital (VC)

investors? If these answers are different, how should Gianforte’s views and desires be

weighed against the other board members / investors?

4. If the company does not accept this offer, what should it do? What is your assessment of

RightNow’s future potential as an independent company, given its new strategy? Assess

the option of going public - what are the advantages and disadvantages?


Venture capital. Financing start-ups and growth firms.

Readings for class

} Stromberg, Per, and Steven Kaplan, “Contracts, Characteristics, and Actions: Evidence

from Venture Capitalist Analysis”, Journal of Finance, 2004, 59, 5, 2177–2210.


Session 16Private Equity


Case

Palamon Capital Partners.

You have been asked by Palamon Capital Partners (PCP) to provide an independent as-

sessment of the proposed investment.

1. Describe briefly PCP’s investment strategy. In your view, what are the major attractive

features of the fund? What are the major risks involved?

2. Discuss the proposed investment in TeamSystem. What are the major risks involved?

3. Determine the value of the 51 percent stake in TeamSystem. Explain the valuation results.

4. Discuss the sensitivity of your valuation results. What considerations should PCP take

into account when making a decision? Are their non-price risks that should be considered

seriously?

5. Deliver your advice to PCP. Should PCP invest in TeamSytem?


Mergers & Acquisitions.

Readings for class

} Block, Stanley B., “The Latest Movement to Going Private: An Empirical Study”, Jour-

nal of Applied Finance, 2004, Spring/Summer, 36–44.

} Leeds, Roger, and Julie Sunderland, “Private Equity Investing in Emerging Markets”,

Journal of Applied Corporate Finance, 2003, 113, 111–119.


Session 17Mergers & Acquisitions


Case

The Hostile Bid for Red October.

1. Strategically, does Red October fit with Koloss? Why is it an attractive target? What

does it do for Menatep Bank?

2. Is the company undervalued at $5 per share, the ”rough” price before the takeover at-

tempt?

3. Using Exhibit 8a projections and the equity cost calculated in Exhibit 8b, how would you

value the shares? Is this cost of equity capital estimate reasonable? What would happen

to the value if you were to use the 50 percent opportunity cost mentioned in the case?

Are the projections reasonable?

4. What is Koloss? Menatep’s bidding strategy? Red October’s strategy in response?

5. What should management do now that K/M has raised the tender offer to $9.50 per

share?


Discussion of corporate governance.

Leveraged buyouts.

Readings for class

} Becht, Marko, Patrick Bolton, and Ailsa Roell, “Corporate Governance and Control”,

Working paper, European Corporate Governance Institute, 2002.


Session 18



Review and synthesis of course.

(Detailed) explanation of final examination.

Final remarks.

Readings for class

There are no readings for this class. Relax!

f331: applied accelerated corporate finance

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