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FINANCE 541

FINANCE 541. Cases in Managerial Finance. Today’s class. Introductions and house keeping Current Events Financial planning and analysis Seminal ideas in corporate finance. My Background. NAME : Ken Shah BORN : Bombay, India PhD : University of Oregon INDUSTRY EXPERIENCE :

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FINANCE 541

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  1. FINANCE 541 Cases in Managerial Finance

  2. Today’s class... • Introductions and house keeping • Current Events • Financial planning and analysis • Seminal ideas in corporate finance

  3. My 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

  4. Academic Experience • Taught at • University of Oregon • University of Auckland • Southern Methodist University • Courses in capital budgeting, corporate finance, investments, and money and banking

  5. Recent 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

  6. Please Introduce yourself... • Please fill out the student information sheet • Drop by my office! • Name cards

  7. Course 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!!

  8. Course Prerequisites • Willingness to learn & work hard! • Understanding of: • Financial statements • Rudimentary statistics • Spreadsheets • Fundamentals corporate finance • Valuation, M&M propositions, agency theory • Pre-requisite: FINC 515

  9. Anticipate... • About 6 - 8 hours of work outside of class • Frustrations with unstructured problem solving! • Frustrations with computer work!

  10. Texts • Required: • Bruner, Case Studies in Finance • Packet of Readings • Optional: • Brealey & Myers, Principles of Corporate Finance • Higgins, Analysis for Financial Management

  11. Evaluation • Group Case Presentation 250 • Participation 250 • Midterm Case 250 • Final Case 250 • TOTAL 1000

  12. Participation Grade • Peer Evaluation • At the end of quarter, you will give one point each to roughly 1/3 of the class who contributed, in your opinion, to the discussion in a positive way

  13. Grading Policy • If you attend all classes and diligently complete all required work, you would be assured of a B- grade • In order to get an A/A-, you must show work of superior quality and make a meaningful contribution to the class discussions • roughly top 15% of the class

  14. Class Attendance • Mandatory • Particularly important in a case class • Please inform me of anticipated absences • More than 1 absence will adversely affect your grade

  15. Case Presentations • In groups • About 30 minutes in length • Formal write up • Field questions

  16. Non-presenting groups • Demonstrate preparedness • Come to class with solution to the selected case question (in bold in the handout) • One group will be randomly selected to turn in the solution

  17. Midterm & Final • Formal 3 page case evaluation • Take home • One week to complete • Individual effort

  18. Readings • 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

  19. Course Design Growing Pains - Private enterprise Midlife crisis - Managing growth Over the hill - Restructurings

  20. Case Progression • Managing Growth / Private enterprise: • Short term financing / Managing growth • Going public • WACC • Sustaining Growth / Financing Policy: • Corporate disbursement policy • Capital structure polic • Lower Growth / Corporate Reorganizations: • Takeovers • LBOs • Bankruptcy

  21. Cases... • Are deliberately vague! • Have information deliberately presented in random order - not in the order of importance • Offer little guidance on method of solution

  22. 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

  23. 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

  24. 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

  25. 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.

  26. 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 judgement, 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!

  27. Case Write-up • Do NOT simply regurgitate the information in the case in your introduction to the case • Distill and analyze the information and present it only if you believe it has an impact on your analysis and solution

  28. Learning 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!

  29. Financial Planning • Analyze financing and investment decisions • Project future consequences of present decisions • Decide on which alternative to undertake • Measure subsequent performance against goals

  30. Elements of Financial Planning • Forecasting • Pro-forma statements • Finding the optimal financial plan • Watching the plan unfold

  31. Analyzing performance • Financial ratios • Beware of accounting definitions • Choosing a benchmark • trend over time • industry counterparts (Dept. of Commerce, Dun & Bradstreet, Robert Morris Assoc.)

  32. Analytical Tools • Sensitivity (what-if) analysis • Scenario analysis • Monte Carlo simulation • Decision Trees

  33. Sensitivity 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

  34. Scenario 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

  35. Monte 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

  36. Decision 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)

  37. Is theory a dirty word? • Theory is simply an exercise in ridding distractions • It can aid to clarify thinking • However, theory for its own sake serves no useful purpose in this class • Theory does provide a framework to start the analysis

  38. Bridging Finance Theory and 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 • Asymmetric Information Models

  39. CAPM • Widely used in NPV, capital budgeting • Efficient Portfolios, CML, SML • Recently under attack (is beta dead?) • Rivals: APT, Empirical Multifactor Models

  40. M-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

  41. M-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

  42. M-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)

  43. Bankruptcy 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!!

  44. Bankruptcy Costs • Direct costs estimates • 3% of book assets • 20% of market equity • Quite substantial!

  45. Agency Costs • Conflicts are inherent between • Share holder - Management • Share holder - Bond holder • Firm value is reduced by • Excessive perk consumption • Taking unwarranted risk • Forgoing profitable investments with debt

  46. Agency Cost Models • Used successfully in explaining • LBOs, Takeover, restructuring activity • Debt covenants • Design of board of directors • Design of incentive compensation

  47. Asymmetric Information Models • 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?

  48. Optimal Capital Structure • Maximizing firm value involves balancing • Tax benefits of debt • Bankruptcy costs • Agency costs of debt • Agency costs of equity • Information signalling costs

  49. Option 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

  50. Option Pricing Models • Binomial • When outcomes at each node are limited in number • Black - Scholes (& variants) • For continuous range of outcomes such as market prices

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